Americans, for the most part, have too much debt. As of November 2020, consumer debt is at $14.2 trillion, with Americans carrying an average personal debt of $92,727.
If you’re in debt, the worst thing to do is ignore it and hope it goes away. Debt management is a task every individual should make a priority.
The Difference Between Good and Bad Debt
To first step to debt management is to take note of how much debt you have and what kind of debt. Debt is often categorized as either good, bad, or reasonable.
Good debt can generally be categorized as debt that will eventually generate income and help you build net worth.
Reasonable debt is when the repayment period may be longer than good debt, but returns are expected to be positive.
Bad debt is when you’re borrowing money to receive something that isn’t going to generate any income.
|Type of Debt||Interest Rates||Repayment Period||Examples|
|Good Debt||Relatively Low||Substantially less than the life of the asset itself||• Home purchase with 15-year mortgage|
• Student loan tied to a profession (e.g. medicine, law, financial planning)
• Car loan with repayment period of 3 years or less
|Reasonable Debt||Competitive||Less than the life of the asset||• Home purchase with 30-year mortgage|
• Student loan for general higher education
• Car loan with repayment period of 4-5 years
|Bad Debt||High||Longer than the life of the asset||• Making minimum payments on credit card debt|
• Car loan repayment period longer than economic life of the car
• Taking on debt for vacations or clothing
How do I pay off my debt?
Now that you know what categorizes debt as good, bad, or reasonable, it’s time to make a game plan.
Debt Pay-Off Strategies
Here are some common strategies to pay off debt quickly:
- Debt snowball
You focus on paying off your smallest debt first (while paying minimums on the others), then roll the amount you had been paying on it into payments on the next largest.
- Debt avalanche
You pay off your debt with the highest interest rate first (while paying minimums on the others), then the next highest rate, and so on. It may save you time and money over the course of your debt payoff.
- Debt consolidation
Combine multiple old debts into a single new one, ideally at a lower interest rate, making payments more manageable or the payoff period shorter. There are a few ways to consolidate debt, including balance transfer cards and personal loans.
- Debt management plan
If you’re facing a mountain of credit card debt and not making much progress, a nonprofit credit counseling agency can set up a debt management plan to cut your interest rate and put you on a repayment plan.
Creating a Budget
One strategy that all individuals facing debt need to live by is a budget. A budget is essentially a spending plan. It ensures that you will have enough money to pay for the things that are important to you, like getting out of debt.
There are three important tips to being successful in preparing and using a budget.
- Be realistic.
Be realistic with spending behavior. It is easy to overlook credit card expenses for shopping or dining out. Credit cards are an easy way to “blow the budget.”
- Don’t forget the miscellaneous.
Budget a line item expense for miscellaneous expenses and unforeseen expenses. Miscellaneous expenses include gifts at the holidays, car repairs, house repairs, traffic tickets, kid’s sporting events, etc. As you get older, the miscellaneous expense item tends to grow.
Being successful with a budget takes practice. The more often you prepare a budget and compare your actual spending to a budget, the better you’ll become at budgeting. The first few budgets are likely to be unrealistic and not very accurate.
A well-thought-out budget will identify spending by major categories. The major categories are:
- Income – includes all salary, wages, dividends, royalties, interest, and business income.
- Savings – includes contributions to retirement accounts, education savings accounts, or any other accounts you deem as a savings goal.
- Debt Payments – includes a mortgage payment, car payments, student loans, boat loans, etc.
- Living Expenses – includes all discretionary expenses, plus non-discretionary expenses, and housing costs. Discretionary expenses include entertainment, vacations, clothing, cable television, etc. Non-discretionary expenses are food, utilities, phone, etc.
- Insurance – includes premiums for life, health, disability, home, auto, long term care, and personal liability.
- Taxes – includes federal, state, and local income taxes, and Social Security.
Over time, you’ll become more comfortable with budgeting and more realistic with spending, saving, and miscellaneous expenses.
Start small and stay committed. Time is your friend when you’re trying to get out of debt.
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Am I on the right track financially?
Be sure to illustrate all your debt for one full viewing to get a good grasp on where you currently stand. This can be done with a spreadsheet, physically writing totals on a sheet of paper, or using a personal finance tool.
Mint.com is a helpful website to organize what you’re spending your money on. Link your financial accounts and Mint will create pie charts and reports for you. Beware: pie charts showing where your money goes can be very sobering.
Once you have all your expenses noted, calculate them as a percentage of your income. For example, if you make $50,000 annually and spend $14,000 annually on rent, this means you spend 28% of your income on housing. This helps you discover where all your hard-earned money is actually going.
Ideally, you should aim for the following benchmarks:
- Taxes = 15-30%
- Savings = 10-18%
- Insurance = 5-12%
- Housing (rent/mortgage) = 28% or less
- Living expenses = 40-60% (when combined with housing)
- Total debt = 36% or less (when combined with housing)
These target benchmarks are generalized and can vary by age and situation of individual.
Mr. and Mrs. Smith went through and wrote down their cash inflows and outflows for the prior year.
|Cash Inflows:||Dollar Amount||Percentage of Income|
|Living expenses||$41,000||27.3% / 50.6% combined|
|Other debt (student loans and car payments)||$11,000||7.3% / 30.6% combined|
Mr. and Mrs. Smith are on target for all benchmarks.
Your percentages may be completely different than those in the example. Calculating these numbers simply helps open your eyes to where you are and what you should aim for.
If your numbers are way off the target benchmarks, this doesn’t mean your case is hopeless. Start small and stay committed. Time is your friend when you’re trying to get out of debt.
This article is for general educational purposes only and is not written by a financial advisor.
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