Debt is an important part of your life. You will most likely be carrying them whether it's a mortgage, a car loan, student loans or even from your family and friends. If you're lucky enough to have never dealt with debt, I truly envy you. Debts are liabilities and it's important to learn how to manage them so your financial life doesn't suffer.
Before acquiring any debt, you should ask yourself why you need to do so. If the reason is because you can or you really wanted to treat yourself to something special, you should consider if you could afford it in the first place. Getting into unnecessary debt will become a decision you will regret if you cannot effectively manage it. It could negatively impact your credit score, have lenders refuse you services, and affect your financial and personal health.
Ideally, you should be aiming to eliminate your debt within a set time period. Before you conquer your debts, it helps to first understand them. Debts are fairly simple but be sure to always understand your finances. The purpose of my blog is to help you learn about financial literacy after all. Debts may contain certain terms and conditions and there are several types of debt. In order to pay them off, you must first plan appropriately and include them in your budget. This means that you need to have enough money after calculating all your other expenses. I have already discussed some of these but I'll list off the most common type of debts:
- Credit cards
- Student loans
- Car loans
- Line of credits
- Mortgages
Debt Broken Down
I've listed them from highest to lowest in terms of interest rates. The middle 3 may be subject to debate but they're roughly around the same rates depending on your personal credit score. Debts have some key aspects you should keep in mind. Make sure you understand the following regarding your debt:
- Principal - This is the loan amount borrowed
- Interest rates - Remember, the rate is always an annual rate
- Fixed or variable - Is your interest rate locked in during the period of your loan or does it fluctuate?
- Payments - How much are you expected to pay and how often?
- Time period - How long are you expected to carry the debt?
- Flexibility - Do you have the option to make pre-payments without penalty? Are you able to stop payments for a period of time? Do you have the option to manually make payments or is it automatically withdrawn from your account?
- Other conditions - Do you need to provide collateral, hidden fees, etc?
Strategies to Pay Off Debt
High-Interest First
Now that you can understand what to look for, how should you go about paying them off? You can use this debt calculator to help you see how long it'll take to pay off your debt. The most common method I see people doing is paying off their smallest debt first. Although it can be reassuring to know that they owe one less debt, it may not always make financial sense to do so. I'll explain with the following example:Credit card debt - $5,000 @ 20%
20% x $5,000 = $1,000 in interest per year
Line of credit debt - $3,500 @ 7%
7% x $3,500 = $245 in interest per year
In this case, it would not make sense to pay off the line of credit with the lower interest rate first because the interest on the credit card is accumulating about 4 times as fast as the interest rate on the line of credit. To pay less in interest, it would make more financial sense to pay off the higher credit card debt first.
Balance Transfer
This method usually only works for credit cards and line of credits. You may be eligible for a balance transfer on these products to lock in at a fixed interest rate for a period of time. Do you recall from a previous post when I told you that it sometimes pays to listen? This is one of those times that can help you pay off your debts. You might have an offer and can transfer the balance of one of your credits to another one that has a lower interest rate. This will slow down your interest payments while you tackle the principal amount owing.Consolidation
This is a good option if you feel like you cannot keep track of all your debts and their interest rates. You could seek to consolidate all your debts into one with a single interest rate. You would apply for a personal loan, usually at a fair or low-interest rate and use the loan to pay off all your other debts. Keep in mind the better your credit score, the lower your rate. You could also use this strategy with a line of credit.Still Unable to Pay?
What if you're drowning in debt and can't afford to make your regular payments? Well, this means you are insolvent. This is the part where your credit score drops for missed payments and you may have collection agencies harassing you to collect their debt. In addition, your financial stress may also impact your personal and family life. Your lenders could sue you for the amount you owe and your earnings may be garnished. This means a court order demands that part of your salary is to be paid to your lenders. Hopefully, you can avoid this situation but there are 2 options at this point. None of which will look good on your credit report.- Consumer Proposal
- Bankruptcy
That's all for this post. I'll explain more about consumer proposals and bankruptcy in another post.
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