Take control of debt by with these tips on prioritizing payments, building an emergency fund and avoiding the biggest traps
Consumer debt is out of control in America. The Federal Reserve reports that households owe nearly $4.0 trillion, that’s $500 billion more than just before the housing bubble burst when debt burdens pushed the country into the deepest recession in nearly a century.
Spending is definitely part of the problem but wages that haven’t budged in nearly a decade also contribute.
Wages have grown by just 2.3% a year since 2007 against prices that have climbed 1.7% according to the Fed. That means workers are no better off even after the economy and the stock market have rebounded from the recession.
Unable to increase their quality of life through higher wages, Americans have turned to more debt to buy the things they want and need. Just paying that debt now accounts for one dollar out of every ten for the average household.
It’s a tough situation to get out of and can lead to borrowing more just to make payments. That can lead to a debt spiral into bankruptcy.
But there are some ways you can control debt, even beat it. You first need to understand different types of debt, how to prioritize debt payoff and then how to keep from becoming a debt statistic!
Understand that Not all Debt is Bad
First, I don’t think we are heading for another massive recession caused by debt. Even though household debt has increased since 2008, most of the increase is in student loans. While I’m not a big fan of the for-profit colleges that account for a lot of the student loan increase and the higher defaults we’re seeing lately, it is still debt that is helping people get jobs and higher wages.
That’s an important point about debt to remember when looking at your own ‘household balance sheet’.
Think of debt as a tool, like a hammer. If you know how to use it, you can build something marvelous and useful. If you use it incorrectly, you can smash things up pretty badly.
A good use of debt is to buy something you need, something that increases in value or that increases your quality of life.
The best examples of good debt are mortgages and student loans. While home prices may rise and fall in any given year, they generally increase a little over the rate of inflation over the long run.
People with a four-year degree earn an average of $1,101 a week according to the Bureau of Labor Statistics. That’s 45% more than those with a two-year degree ($761 per week) which itself is 14% above the $668 per week earned by high school graduates. Just looking at the numbers overlooks the greater job flexibility and options college graduates enjoy.
Of course, there are other types of debt that do not help you improve your quality of life. In fact, some types of debt are notorious for ruining quality of life.
Running up high-interest credit card debt can send monthly payments out of control. Pretty soon, you’ve maxed out your cards and need a cash advance to keep checks from bouncing. These cash advance and payday loans, with fees that amount to nearly 500% annual interest, are the beginning of a debt spiral from which few escape.
- Don’t be afraid of debt if it’s to buy something that will improve your quality of life or if it’s to buy something that will increase in value.
- Avoid debt to buy things that don’t last more than a few years or to buy something you could save for and pay with cash in a few months.
Controlling Debt Starts with Your Spending
I know the article started off talking about how wages have barely grown and that paychecks just don’t seem to cover the necessities…but there are also likely things in your spending that can be cut back a little.
Cutting back doesn’t mean you have to skimp forever or that you can’t have fun with your hard-earned money. If your debt is getting out of control, you might need to cut back spending for a few months until you pay down the burden but that doesn’t mean you must live like a miser for the rest of your life.
Try a few of these debt tricks to get your spending under control.
- List your monthly spending by need, from the absolute essentials to the stuff you can do without. Don’t list the amount spent. A lot of the frivolous things that stay in our budgets are things that don’t cost very much. People know they don’t need them but reason that it’s only a few bucks a month. Looking at spending without prices will help you cut the things you know don’t matter.
- Turn your budget upside down. Instead of saving what is left after expenses are paid, take out a small amount for saving first and then budget for expenses. If you don’t have enough then it forces you to cut expenses instead of foregoing saving.
- Try a one month no-spending challenge. Go one month where you cut something completely out of your budget. You’ll save a bunch of money and may just find that you really don’t miss some of the stuff that was breaking your budget.
Even a good hammer, if used incorrectly, can be dangerous. Mortgages and student loans may be generally good but can still get you in trouble if you don’t use them responsibly. Borrow only the amount you need and only at rates you can afford. If you aren’t able to get a loan at affordable rates, try working on your credit score for six months and try again.
Focus on those High-Rate Debts First
There are two strategies to pay off debt, the snowball and the avalanche.
The avalanche method involves listing your debt from highest to lowest interest rate. This would normally put those pesky credit cards on top and mortgages or student loans on bottom. You still make the minimum payment on all loans but any extra money goes to paying off debts at the top first.
The snowball method involves listing your debts by amount owed, from smallest to largest. Any extra money goes to paying off the smaller debts first to knock them off the list.
The avalanche method, paying down high-interest rate debt first, will save you the most money. Those credit cards and other high-rate debt can cost hundreds a month in interest and put you in the poorhouse. This is the debt payoff method you should choose if you are able to stick to your budget and make extra payments on your loans.
The debt snowball method isn’t without its advantages. Paying extra on the smaller amounts first means they’ll drop off your list quickly. If you’re having trouble keeping to a budget, the motivation from seeing debt drop off your list may be enough to keep you saving.
- Pay off high-interest rate debt first to save more money and if you are able to keep to your budget.
- Use the debt snowball method if you need a little more motivation and want to see debts drop off your list of burdens.
Avoid the Debt Payoff Traps
Debt companies aren’t going to make it easy for you to get out from under their thumbs. The longer you rely on their money, the more interest you’ll end up paying.
There’ll be all kinds of debt payoff traps in your way, from easy ways to miss your goals to things that will completely throw you off your plan.
- Don’t think the minimum payment is enough. Paying only the minimum on your credit cards will keep you paying interest for years. On most cards, you’ll end up paying nearly double for the things you buy. Even if you can’t pay your cards off each month, pay a little extra above the minimum.
- Avoid carrying credit cards with you when you shop. Use debit cards instead so you only spend money you have available. This will also give you time to think twice about a big purchase if you have to go back home to get your credit card.
- Set realistic goals for budgeting and paying off debt. Trying to save every penny and not enjoying your money a little will leave you burned out, resulting in a spending binge every few months. Cut back gradually to pay more towards debt, increasing your extra payments each month.
Emergency Cash can Save Your Financial Life
Emergency medical bills are reported in more than half the personal bankruptcies filed each year. Borrowers also list car troubles and other one-time debt as biggest reasons for losing control of their finances.
You can spend months paying down your debt but it could all go out the window if you don’t have an emergency fund for unforeseen bills.
This means saving at least between three and six months’ worth of expenses. That’s not going to happen overnight but putting a few hundred a month into an account will get you there eventually.
- Pay off credit card debt and any other debt with rates above 14% first with any extra money each month. Even if you aren’t able to start on your emergency fund yet, you’ll save lots of money in interest payments.
- After credit cards are paid off, prioritize building up an emergency fund so those little ‘life happens’ moments don’t put you back in debt.
- After you’ve got a few months’ worth of expenses saved, go back to paying off debt and investing to meet your long-term goals.
Watch where you Borrow
Lenders get a bad reputation, some for good reason. While debt is a tool, there are a lot of people that will take advantage of you when you visit their ‘hardware store’ of money.
I’ve used personal loans, mortgages, home equity credit, credit cards and just about every type of loan available. I’ve even used a cash advance once…just once.
Some types of loans are notorious for predatory lenders but even some of the good loan types can get you in trouble if you go to the wrong company. It can be tough to separate the good lenders from the bad but follow a few tips and shop around when looking for your next loan.
- Watch out for lenders offering very short-term loans, especially loans that need paid back in six months or less. These are some of the highest rate debt allowable even if it doesn’t look like it because the reported interest rate isn’t an annualized rate.
- Watch out for personal loans and other debt that charges a fee beyond the interest rate. Bad credit loan websites know they can trick people by offering low rates while hiding fees that make the annualized rate much higher.
- Shop around for your loan. Most lenders will do a soft-pull of your credit first to approve and estimate a rate. This doesn’t hurt your credit score so there’s nothing wrong with checking your rate from three or more lenders.
Don’t Wait to Be Debt-Free before Investing in Your Future
Debt-free is a big buzzword with personal finance blogs. Everyone has a story about paying off tens of thousands in debt and wants to tell you to live a debt-free life.
Debt can be crippling. I get it. Debt can ruin your financial life and cause problems in your personal life if not controlled.
But debt-free shouldn’t be your #1 priority at the expense of everything else.
Life happens and can put you in and out of debt for decades. You may never be completely debt-free but you will absolutely need to retire someday. Prioritizing debt-free can leave you with nothing to live on and no hope during retirement.
Prioritizing debt or avoiding loans can also keep you from getting the education you need that can help increase your wages and improve your quality of life.
Be responsible with new debt and make a plan to pay off old debt but not at the expense of larger, longer-term financial goals including investing and education.
Controlling debt can be difficult for anyone but especially when income doesn’t seem to cover the necessities. Paying off your debt when you don’t make enough means understanding how to prioritize your loans, avoiding the worst debt traps and getting back on track.
About the Author
Joseph Hogue is a financial expert and investment analyst. After serving in the Marine Corps, he started his career investing in real estate before becoming an investment analyst for some of the largest private investors. He's appeared on Bloomberg and on CNBC as an investment expert and has published ten books in personal finance. Now he helps investors reach their financial goals and invest in the stock market with some of the same advice he used when working for the rich.