Debt is a common thread in the fabric of American life. According to a 2014 analysis by the Federal Reserve, the average household carries $15,611 in credit card debt, $155,192 in mortgage debt and $32,264 in student loan debt. Is it possible to dig yourself out of a $203,067 hole? Where should you start? The answers to these questions are the difference between credit health and ruin. Read on to learn the basics of debt prioritization and reduction.
- Make a list. Understanding the facts is imperative. If you have been avoiding the bottom line, now is the time to dust off the bills and tally your debts. Create a list of responsibilities, include the balance, minimum payment, interest rate and due date for each. For example:
Scarlett is a 33-year-old high school science teacher. She is recently divorced and has a four-year-old boy. She and her ex split the marital debt during divorce proceedings last year. Currently, Scarlett’s responsibilities include:
Consider debt types. Scarlett’s debts total $33,750, a hefty sum for a single mother on a small income. Overwhelmed by the balance, she is unsure how to tackle the repayment process. If you’re in a similar position, begin by separating debts by type. Scarlett’s debts are divided into two categories:
- Revolving: An open-ended form of credit that allows the borrower to charge varying amounts each month based on credit limit. Interest rates and minimum payment amounts fluctuate based on the account balance and shifts in the market. Credit cards are the most common type of revolving debt.
- Installment. A loan for a certain amount to be repaid in equal installments over a fixed amount of time. For example, Scarlett’s student loan of $12,500 has a 20-year repayment period, allowing her to make fixed payments of $52 per month. Similarly, her five-year car loan (originally $19,500) is divided into monthly payments of $325.
- Assess risk. After categorizing debt, it’s important to assess the risk of each account. From a budgeting perspective, installment debts provide greater security because interest rates and payment amounts are fixed and predictable. On the other hand, Scarlett’s car will be repossessed if she fails to make payments, and her wages will be garnished if she ignores her student loan. Damage to her credit would also be significant. While failing to pay her credit card bills won’t result in repossession, a collection citation will remain on her credit report for up to seven years as well. The bottom line: All debts carry risk, and Scarlett should make every effort to pay the minimum balances each month. When it comes to paying off her debts early, risk implies the following ranking:
- Federal student loan
- Car loan
- Prioritize. Scarlett’s has prioritized her debts, but why are some ranked higher than others? When deciding which debts to tackle first, consider:
- Interest rates. Scarlett decides to pay off her MasterCard before her Visa. Why? The inflated balance and interest rate will accrue more quickly, affecting her overall debt and making it more difficult to repay the principal amount. The sooner she makes extra payments, the better.
- Credit utilization. Where will your efforts have the most impact? Although Scarlett’s student loan carries the highest balance, its low interest rate and fixed payment poses little threat to her budget. By focusing on a revolving debt with a high balance and interest rate, she plans to improve her credit utilization ratio as quickly as possible. In fact, once her debt is eliminated, she will reduce her ratio by 12.5 percent.
- Get creative. Scarlett learned the value of analyzing debt and creating a repayment strategy, but can she afford to stretch her budget? The average family operates on a fixed income, and making additional debt payments is easier said than done. Get creative with your energy by:
- Auditing your budget. Pursuing a lifestyle change is difficult, but it’s possible with an aggressive budgeting audit. Take a look at your expenses and begin by cutting 10 percent across the board. Clip coupons, pay attention to utility use and curb entertainment spending.
- Eliminate unnecessary costs. We all have them. Whether it’s a daily trip to Starbucks or an expensive cable package, eliminating these costs can add up to major savings.
- Find another income. The Internet is an open door to extra income. Look for a part-time gig transcribing records, becoming a virtual assistant or putting your professional skills to use. FlexJobs.com provides a full list of online opportunities.
The bottom line: Debt is a universal burden, but it takes individual skill to control it. Keep your finances under control by sticking to a strategy. Your credit score depends on it.