Editor’s Note: This article is adapted from “Spending vs. Saving vs. Debt Repayment,” Chapter 2 of The High Achiever’s Guide to Wealth. Pick up your own copy here to read more on this topic and many others.
Debt can create a vicious cycle, as compound interest makes the problem progressively worse. Not only does it cost you money, but it can detract from reaching your long-term financial goals.
At the same time, debt can often trigger feelings of shame or appear to be an insurmountable problem. Try to keep your debt in perspective and remember that you can take concrete steps toward paying it down. Debt is not a problem to solve overnight, but in most cases, it is solvable. You should also remember that you are not alone. In late 2019, the Federal Reserve reported that American households owed a collective $14 trillion – and that was before the stresses of the COVID-19 pandemic. Debt is a reality for most people who own homes or cars, or who pay for their own or their children’s education.
Becoming debt-free has obvious benefits. You will no longer accrue interest, and you can devote money that you previously budgeted for debt to other priorities. But even decreasing your overall debt has advantages. For example, when you apply for a mortgage or auto loan, lenders often consider your debt-to-income ratio. This figure is the sum of your minimum debt payments divided by your gross income. As a rule of thumb, lenders want to see that annual payments on your debt do not exceed 36% of your adjusted gross income (gross income minus specific federal tax deductions). If you can get your overall debt lower, even if it isn’t yet down to zero, you open your financial options in a variety of ways.
Types Of Debt
Not every sort of debt is created equal when it comes to your financial health. You may have heard financial professionals talk about “good” debt and “bad” debt before. This is common shorthand in financial planning. While the reality is more nuanced, this distinction does spring from a real difference.
Most advisers who talk about “good” debt mean low-interest debt that helps you to increase your net worth over time. “Bad” debt is high-interest debt used to pay for nonessential purchases. Some financial planners also favor secured debt over unsecured debt. Secured debts involve collateral, such as auto loans or mortgages. There is nothing inherently better about secured loans, but in practice lenders often offer lower interest rates when collateral is involved. Some debts fall into the gray area between “good” and “bad.” Others may start in the “good” category and morph into “bad” debt as circumstances change. Some debts don’t fit this paradigm at all. For instance, medical debt usually bears no interest, and no one takes it on voluntarily. Yet even if this paradigm is oversimplified, comparing types of debt can help you to think about your debt more clearly and to approach it in a thoughtful way.
The most common form of so-called bad debt is consumer debt, such as credit card debt or personal loans to pay for things such as vacations or high-end electronics. Avoid this debt as much as possible and pay it off as quickly as you can. Credit card debt is subject to high interest rates and contract terms that do not favor the borrower. Many credit cards set annual percentage rates, or APRs, between 15% and 18%. Borrowers with bad credit face even higher rates. And compounding means that even a small balance carried month to month can balloon more quickly than you expect.
A mortgage is the traditional example of so-called good debt. Many mortgages offer interest rates well below what you could earn through investing in a diversified portfolio. This means you may be in less of a hurry to pay it down than higher-interest debt. Mortgages are also designed for borrowers to pay them back over years, rather than pay them off month to month. You can typically refinance your mortgage to change the loan term or the interest rate. And while the housing crisis of the 2000s was a vivid reminder that property does not always appreciate, in most cases your home will gain value over the course of a 30-year mortgage. (For more on mortgages, see my colleague Eric Meermann’s recent article “Buying Your First Home: Down Payments And Mortgages.”)
Small-business loans are also usually good debt. While starting a small business involves risk, securing a loan will require you to create a comprehensive business plan. This means you are unlikely to take out this sort of loan thoughtlessly. If you approach this debt with care, a loan to get your business underway can ultimately prove a net positive for your financial outlook.
A common loan that may be either good or bad, depending on who you ask, is an auto loan. Since cars depreciate, it is usually better to buy them outright if you can. On the other hand, auto loans are different from other forms of consumer debt. Because the car serves as collateral, auto financing rates are usually low enough to make these loans less burdensome than credit card debt. Like mortgages, they can be refinanced or renegotiated if necessary. And in many parts of the country, a car is a necessity to get to work, supporting your ability to earn an income. As long as you avoid going underwater – owing more than the car is worth – you can always sell or trade in the car if you can’t afford the monthly payments.
Educational debt, too, can be either good or bad. Most advisers see loans to attend an accredited university as positive. This is especially true if the amount you borrow is in line with your expected future earnings power. Student loans with oversized balances relative to your intended career, loans for an unfinished degree or loans to attend a disreputable institution are likely to become bad debt. Note that a particular hazard of student loans, whether private or governmental, is that they usually cannot be discharged in bankruptcy.
Paying Down Your Debt
No matter your approach to paying off your debt, never neglect minimum payment amounts. The first step to mastering your debt is to make sure you understand what you owe and that you have budgeted to meet the minimums month in and month out.
Once you are secure in meeting the minimums, the way to pay down your debt is to budget more than this baseline amount for debt repayment. You want to not only pay off the interest each month, but slowly work down the principal balance. There are a variety of approaches you can take, but in general, it is always best to focus these extra payments on one debt at a time. A study published in the Journal of Consumer Research in 2016 found that borrowers who paid one debt at a time repaid their overall debt 15% faster than borrowers who dispersed extra payments among several loans. Assuming you have multiple debts, the question becomes how to select which one to chip away at first.
As you design your repayment plan, consider an approach that naturally gains momentum as you stick with it. Two popular strategies that fit the bill are the “debt avalanche” and the “debt snowball.” In the debt avalanche method, you rank your debts by interest rate, from highest to lowest. You concentrate on the debt with the highest interest rate first. The debt snowball method also involves ranking your outstanding debts, but by outstanding balance, from lowest to highest. You pay off the debt with the lowest balance first, giving you fewer debts to think about as you clear the smaller balances. In either case, once you’ve paid off the first loan, move the additional payment, plus the former minimum on the loan you’ve finished, to the next debt. Treating the former minimum payments as if they never went away protects you from spending extra income elsewhere. It also helps build your repayment momentum.
The debt snowball and debt avalanche both have pros and cons. The debt avalanche method means paying less in interest overall, but it can be psychologically challenging. Many borrowers find the debt snowball method easier to stick to, as it overcomes many common psychological barriers that can hinder repayment. You may become debt-free faster with the avalanche method, but only if you can commit to the plan in the face of what may not seem like much progress at first.
Stay mindful that you must prioritize certain debts regardless of their balance or interest rate. You should always pay back taxes you owe to the Internal Revenue Service promptly, for example. The IRS has the power to impose liens to make sure you pay, and you could face fines or even jail time if you willfully neglect your tax obligations. You should also be sure to read your loans’ terms carefully. Certain personal and auto loans can penalize borrowers if they pay back too much of the loan ahead of schedule.
Pay attention, too, to any associated tax benefits you may be drawing from your debt when you make your repayment plan. You can deduct up to $2,500 of qualified student loan interest against your taxable income each year (subject to an income phase-out). This effectively reduces the actual interest you pay on these loans. Mortgage interest is also deductible on loans up to $750,000 annually (or up to $1 million if you purchased your home on or before Dec. 15, 2017). If you use the avalanche method, you may want to adjust the interest rates on these loans to reflect the associated tax benefits.
Depending on the types of debt you carry, you may find their sheer number and policy details overwhelming. In this case, there are some other tools that can help you get a handle on your debt.
First, you may want to consider debt consolidation. If your credit score is good, your bank may provide you a loan designed to let you consolidate your credit card debt. Depending on your credit score, the interest rate on this loan will often be lower than the credit cards’ APR. This can both reduce the number of payments you have to remember and save you money in interest. If you have student loans, you may want to consolidate them too. Bear in mind that government-issued loans may have useful characteristics you could lose if you consolidate them with loans from a private lender. The details of student loan consolidation are beyond the scope of this article, but you can read more about the process in Chapter 4 of The High Achiever’s Guide to Wealth.
If you are close to paying off your credit card debt but need a small boost over the finish line, you may want to consider applying for a new card that offers a promotional balance transfer with a 0% interest rate. Use this strategy with care. Promotional offers tend to cover a relatively short time span before they revert to high rates. But if you have a decent credit score and the ability to pay off the rest of your balance quickly, this window can help you to close out a lingering credit card balance.
Don’t discount the possibility of negotiating directly with your creditors if necessary. If you are at high risk for default, or if you are contemplating the possibility of bankruptcy, your debt issuers face the prospect of a total loss on your remaining debt. They will often negotiate a new interest rate or structure a repayment plan to avoid this outcome.
As you pay down your debt, be honest with yourself about your habits and inclinations. Your debt may not have anything to do with your behavior, as in the case of major, unanticipated medical bills. Or you may regularly max out your credit cards as an unhealthy coping mechanism for stress. Maybe you bought a more expensive car than you really needed; maybe your car unexpectedly broke down and you could not cover repairs from an emergency fund. For many people, paying down debt is as much a psychological exercise as a financial one. Do not let shame or fear paralyze you. Instead, commit to whatever systematic approach you believe you can stick to. Month by month, you can pursue your goal of becoming debt-free.
Everyone makes less than perfect financial choices sometimes – even professionals. Take a clear-eyed look at your past decisions and your future options. Then make a plan and get started. The sooner you begin, the sooner you can celebrate conquering your debt.