Since the financial crisis, consumer credit in its many forms—from student loans and mortgages to auto loans and credit cards—has grown. In recent years, a strong economy and job market have encouraged many people to spend and borrow more.
Not all debt is harmful to your financial health. In fact, many people divide borrowing into good debt and bad debt. Good debt is used to finance goals that will increase your net worth, such as earning a college degree, buying a home or owning a small business. Good debt is even better if it carries a low interest rate and is tax-deductible. Bad debt is money borrowed to buy things that won’t last or that you can’t afford, such as a Coach handbag that you charge to your credit card but don’t pay off, or a trip to Cozumel that you finance with a home equity line of credit or personal loan.
Sometimes the boundaries between good and bad debt aren’t as clear. Many experts consider loans for cars or other depreciating assets to be bad debt. But if you take on debt to buy or repair a car you need to get to work or to pay for a necessary medical expense, that debt falls somewhere between good and bad, says Michele Cagan, a certified public accountant and author of Debt 101.
Still, too much debt of any type is overwhelming. And even good debt can turn bad when you have too much of it, as happened for many households in the years leading up to the 2008 financial crisis. But rather than forgoing debt altogether, the key is understanding the purpose of the debt and what you can afford, says Cagan. If you’re considering taking out a loan, make sure you understand the details—including when you’ll need to start making payments, what the interest rate is and other repayment terms. Consider how those payments will fit into your budget.
Strategies to pay it off. Once you’re on the hook to pay back money that you borrowed, the strategy is the same, no matter how much you owe. Start by taking inventory of the amount you’ve borrowed, the payment dates, the lenders and the interest rate for each of your debts. Build the minimum payment for each debt into your monthly budget. (If you’re having trouble meeting the minimum-payment amounts, see below.) Then see how much more you can afford to put toward your debts, and make a plan to speed up repayment. It might stretch your budget to make larger payments, but paying down your debts more aggressively will help you wipe them out more quickly and save you hundreds, if not thousands, of dollars in interest.
Simple math shows that paying off your debt with the highest interest rate first, while making minimum payments toward the others—known as the avalanche method—will save you the most money. But some borrowers prefer what’s called the snowball method. With this strategy, you tackle the debt with the smallest balance first, then roll that payment into the next smallest debt. Creating a snowball isn’t the fastest way to get out of debt, says Cagan, but it can help borrowers stay motivated because they can see their progress.
Other strategies to manage your debt will depend on the types of debts that you have. Because today’s interest rates are low compared with historical rates, you may be able to refinance some of your debts at a lower rate and use the extra cash to speed up repayment or boost your savings.
