People who have a lot of debt often take a “why bother?” attitude about money management. They’re in so deep that practicing good money management behaviour just seems fruitless.
But that’s wrong and it’s hurting a lot more people than most people realize, with the average Canadian owes just over $7,000 to banks.
Actually, no. There’s a solution for every type of debt (even the worst types). You just have to find the one that’s right for you.
Here’s your guide for doing just that: planning a roadmap for reducing and removing your debt. Spending the next seven minutes reading this guide could change the rest of your (financial) life.
1. Set Your Priorities: Not All Debt is the Same
The first thing to know is that debt can wear many clothes. From the school loan you took out to the Visa bill you racked up on last year’s trip to Bali, there’s a hierarchy of debt from good to bad. This is important to understand because it’s going to help you later on when you start building out your action plan.
Basically, debt can be categorized based on how urgent it is to pay it off quickly. The sense of urgency stems from high interest rates. Many of the so-called “good” types of debt have very low interest rates compared to those of the “bad” and “ugly” types of debt.
Lots of times, debt is useful — like a business loan that helps you start a new career (or grow the one you have). And debt can be used to get access to life-saving medical care. In some cases, people even use one kind of debt to pay off another type of debt.
- Ugly Debt. High-interest credit cards (hello trip to Paris). Ugly debt is often taken on when you’re making a costly purchase for something you may not really need. It takes you longer than expected to pay it off and you start accumulating late fees and eventually higher interest rates because your credit rating goes down.
- Bad Debt. Like ugly debt, this is debt where you aren’t paying off the balance in a timely manner. But you haven’t missed payments and it’s only been a few months of paying interest. This typically happens a necessary purchase is made that you can’t quite afford.
- Good Debt. Student loans, business loans, mortgages. Each of these types of debt are helping you to achieve a better life: i.e. adding more value to your life. You’ll also hear this kind of debt referred to as “productive” debt.
2. Pick a Strategy for Reducing (or Removing) Your Debt
You’ll want to choose your method for chipping away at that debt:
- Debt Snowballing. This strategy is a lot like plate-spinning. You have several things you keep going at once until, one by one, they fall. Each month, take your spending budget and apply it to paying the minimum balance on each of your debts. Anything left over should be used to start paying down the debt that has the lowest balance. Once that’s paid off, you’d use your extra cash to start whittling away at the debt that has the next-lowest balance, and so on. One at a time, those plates (debts) are falling.
- Debt Stacking. There is one problem with Debt Snowballing. It doesn’t take into account the various interest rates on different kinds of debt that you have. Wiping out a debt where the rate is 5% gives great satisfaction but if you’re ignoring that 27.8% rate on the credit card debt, you still have a problem. Debt Stacking is when you prioritize your pay-off-first card by how high the interest rate is. So, just like in debt snowballing, you pay the minimum balance on each debt each month. With your extra money, you pay down the debt that has the highest interest rate.
3. Consider Consolidating Your Debt
Sometimes, debt consolidation is a good idea. One of the beauties of using a personal loan to consolidate your debt. It won’t hurt your credit score because lenders don’t do a hard pull on your credit history. It’s important to always monitor and even try to improve your score so that it benefits you the most when the time comes that you might need a loan. It isn’t a quick process, and something to keep working on. Otherwise, you might find yourself with few options than high interest rates when you need to borrow and stuck trying to get approved with bad credit.
Lots of people use personal loans to consolidate their debt. Personal loans let you lump all your different balances together into one payment that’s much easier to handle. Beyond that, there are several other good reasons to consider a personal loan for debt consolidation:
- Fixed Rates. Rates on personal loans do not fluctuate so they are resistant to the effects of wild swings in the economy.
- Lower Rates. Personal loans typically have lower rates than most credit cards. This is what makes them great for consolidation because you’ll be shedding those high-interest credit cards. Less interest means lower payments and a faster path to paying off the debt. And the bonus: if your credit is good, you get even lower rates.
- No Collateral. Unlike many other types of loans, personal loans don’t require you to put up anything for collateral.
There is, however, one instance when debt consolidation might not be the answer. While it’s possible to get a personal loan when you have bad credit, make sure you look at what your rate will be. First, figure what combined average rate you’re currently paying on all your loans. If your consolidation plan results in substantially higher rates than the figure you came up with, then it might not be worth the convenience of one monthly payment.
4. Start Thinking About Budgeting
If you’re ever going to be able to save money and start accumulating a little nest egg for yourself and/or your family, you’ll have to think about budgeting. Even right now, when your goal is to reduce or remove your debt, it’s essential that you examine your spending. The golden rule of good money management (only way to make progress against both of those goals) is to spend less than you earn.
While you’re at it, consider adding an emergency fund to your list of financial things to do. This will help you stay out of debt. When the dishwasher starts flooding your kitchen or somebody gets their hours cut at work, you’ll have a cushion of cash to fall back on.
In closing, here’s some advice on how to avoid mistakes in your debt reduction journey.
- Don’t fall for the old “lower monthly payments” bamboozle. It’s easy to lower your payments: simply extend the terms of the loan. It’s simple math: you’ll end up paying more in interest. What you want is to lower the amount of interest you’re paying in order to save money.
- Don’t forget that a secured loan many mean lower rates but it also means more risk. When you put your possessions or property up as collateral for a loan, you run the risk of losing them if you default on the loan.
- Don’t take a personal loan for debt consolidation with the services of a debt settlement company. Debt settlement means hiring a company to negotiate with your creditors to lower the amount you owe. This may sound ideal but there are a few caveats. For starters, it can be a costly path to take. Debt settlement is also a lengthy process — sometimes taking years! Another warning: you could even end up paying more in interest over the lifetime of the loan than you would have. This happens when the repayment term is extended. Finally, when you settle your debts with a debt settlement, it can have a powerfully destructive impact on your credit score. To improve your rating before apply for a loan will be a move you’ll never regret in future. It’s likely to help you qualify for better loan rates and that’s never a bad thing.
No matter what, you’ll always owe that money. Even if you simplify your life by taking out a personal loan, you’re not reducing the amount you owe until you’re actually paying it down with cold, hard cash. Follow a sound plan, keep at it, and you’ll soon be on the road to financial health.