- How you can stop avoiding your monthly debt payments.
- Give yourself a reality check and make a financial action plan.
- Decide whether you should pay off the highest interest rate loans or the smallest debts first.
While clinking your champagne flutes (or shot glasses) to toast our entrance into 2016, you probably had a flash of blind optimism about the New Year. A fresh start means you can finish writing that novel you just know could get optioned for a movie, shed those 10 pounds that have been following you since college, or truly tackle your financial issues. But here you are, January nearly gone, and you’ve hit writer’s block, gained two pounds, and shiver at the thought of logging into your bank account to address your money problems.
You aren’t alone.
I’m an amateur personal finance geek.
Your tools have helped me become a smarter investor.
Personal Capital Dashboard User, February 2021
Unfortunately, coddling and gold stars aren’t going to get you financially healthy. It’s time for some tough love and real talk about money.
Stop Hiding From Your Monthly Debts
We all love a good benchmark. You know, the kind that says you should have the equivalent of your annual salary saved by 35 or that you need at least six months worth of expenses saved in an emergency fund. The kind of numbers you can measure against and say either, “Hey – I’m not doing so bad!” or “Crap. I’m doomed…”
Benchmarks and percentages are also very useful when handling debt. Sure, I could lecture you that owing $1,000 a month in student loans or auto loans or credit cards is just way too much – but it may not be the case.
$1,000 worth of debt owed per month can either be a shockingly overwhelming number that eats up half of your post-tax income, or it may be a manageable, yet painful, number.
So, let’s talk about percentages instead of hard numbers. A good rule of thumb is to keep your debt-to-income ratio at or below 36%. This is your total monthly debt divided by your monthly gross income.
Why does this rule matter? First, it matters because it helps keep you out of bankruptcy court. Second, because if you need to apply for a loan – even one to consolidate existing debt – your debt-to-income ratio will be a factor. Yes, it’s ideal to have 0% debt, but thanks to student loans, your desire to own a car so you can actually get to work, or the hope to buy a house, you might need a loan while you’re working on paying down debt.
Know These Numbers
Other benchmarks to keep in mind while paying down debt:
• 10%: Work on saving 10% of each paycheck with the intention of saving more as debt gets paid off.
• Match percentage: Contribute at least enough to get an employer match on a retirement account – brownie points if you contribute more!
• $1,000: Save a minimum of $1,000 in an emergency savings fund – and then begin tucking away six month’s worth of expenses.
Your Reality Check
You may be trying to avoid calculating the grand total of your debt – but now it’s time to get out your calculator (or your phone) and do the math. I can wait while you do it…
All tallied up?
Before you go freak out about the total, there are a few other things you need to know.
1. With a few exceptions, student loans don’t discharge in bankruptcy.
2. Your credit reports and score are going to matter when you make your debt repayment action plan, so take the time to pull your reports (you can do this for free at annualcreditreport.com) and check your score (easy and free using sites like Credit Sesame).
Now let’s talk about how to handle that debt. First step is to make a budget. Sorry, you must. There is no way to effectively pay off debt if you don’t know how much money is coming in and how much money is going out.
There are two main schools of thought when it comes to debt repayment: debt snowball and debt avalanche.
Debt snowball goes for the psychological win by ordering your debts from smallest to largest regardless of interest rates and paying off the smallest debt first. Then the money used to pay off that debt gets moved to paying the next smallest debt and so on. The mental boost of getting rid of a debt is meant to give you motivation while you disregard the mathematical implication that paying off debt this way means more interest accrues.
Debt avalanche comes from a pure mathematical perspective and tells you to rank your debts based on interest rate, and then chip away at the highest interest rate first as work your way down the list.
Decide which one makes you feel more empowered, and do it. Now let’s move on to identifying your debt repayment personality, and how you can leverage it to tackle specific types of debt.
A majority of Millennials will tussle with student loans. These debts can be staggeringly high, especially when compared to income. Fortunately, there are three good tactics for dealing with this debt. It’s easy to figure out where you’d belong just based on your level of adulthood. Which one of these sounds most like you?
1. The “I’ve Got Dreams To Save The World/Be Famous/Never Get A Real Job”
In which you learn how to use an income-driven repayment plan and/or student loan forgiveness to pursue your dreams without having your debt sent to collections.
Those with federal student loans may be eligible for an income-driven repayment plan or student loan forgiveness. Income-driven repayment plans cap your monthly payment at a certain percentage of your discretionary income. Or in laymen’s terms: if you owe $75,000 in loans but only make $35,000 a year, your payments will be more affordable. There are four main plans: Income-Based Repayment (IBR), Pay As You Earn (PAYE), Revised Pay As You Earn (REPAYE) or Income-Contingent Repayment (ICR). Any remaining balance after 20 to 25 years of payments will be discharged.
Depending on your type of loan and your career, you may also be eligible for student loan forgiveness.
2. The “Adulting 20-Something”: Aka I’ve Got A Strong Credit Score And A Job
In which you figure out that refinancing your loans may be the right move for you.
The explosion of student loans led to the rise in student loan refinancing. Start up companies such as SoFi, Earnest and CommonBond provide a way for graduates to consolidate and refinance existing loans, both federal and private, to a lower interest rate. This is almost always a smart move when dealing with a private student loan, but you must evaluate the decision before refinancing a federal student loan. Refinancing will mean you give up federal perks like forgiveness, income-driven repayment plans, deferment or forbearance.
3. The Grownup: I’ve Got Excess Cash Each Month After Paying Bills, Feeding Myself And Saving Money
In which you realize that paying more than the minimum means you can avoid massive amounts of interest and ditch the debt albatross sooner rather than later.
Getting aggressive about your payments is another way to dig out of the student loan debt hole early. Pick up another job, get a roommate, eliminate most unnecessary expenses or whatever it is you have to do to be able to put a little extra towards loans. Once you pay above the minimum, you should also tell your lender where you want the money applied. Don’t leave it to the lender’s discretion because they can get a little tricky about applying it to future interest instead of the principal balance.
Credit card debt is ugly and gets expensive fast. The interest rates can be close to, if not above, 30%, which can mean taking years to pay off a few thousand dollars for some. Similar to student loans, there are three ways you can start getting aggressive about digging out of credit card debt.
4. The Gamer
In which you figure out how to beat the banks at their own game by properly utilizing a balance transfer without falling into any traps.
Solving credit card debt with a credit card? This sounds completely insane, but for the diligent, it’s an easy solution. Debt is incredibly profitable and when you’ve been in debt once, a bank is pretty sure you’ll do it again. So, Banks offer balance transfers in order to entice individuals into moving their debt over. There is usually a promotional deal like 0% APR for 21 months with only a 3% fee for moving the debt. Then you have 21 months to have all the payments you make go towards the principal balance. Those with larger credit card sums (usually above $1,000) and the dedication to pay it off could dig out of debt quickly and shave off a lot of interest. Just be sure not to use the balance transfer card for any purchases!
5. The Likes-To-Play-It-Safe
In which you consolidate your debt, probably reduce your interest rates, but get too nervous about using another credit card and opt out of 0% APR.
A personal loan may be a less risky way for you to consolidate and repay credit card debt. Instead of dealing with another credit card, you take out a loan to pay off the existing credit cards. Then you will just make one monthly payment on your loan, which has a definitive end date. This will cost more in interest than a balance transfer, but it doesn’t open you up to the risk of incurring more debt. It also provides the ability to consolidate several credit cards into one payment.
6. The Makes Minimal Effort (Or Has No Other Option)
In which you don’t yet have the credit score to be eligible for a balance transfer or personal loan, or you just can’t be bothered and pay right above the minimum due praying it gets rid of your debt quickly.
Paying above the minimum is always a good idea. Credit card companies really want you paying just the minimum because it earns them the most in interest and you will take ages to dig out of the hole. Pay as much as you can above the minimum each month to help chip away at the principal balance.
Just Get Started
No matter which strategy you pick, or what type of debt (or debts) you’re paying off – the key is to get started. To keep you motivated, you can track your progress with a free app like Personal Capital.
Now go make a plan, and stop delaying until your next promotion, tax refund, or lottery scratch-off win takes care of your money woes.