Debt is a double-edged sword. When wielded wisely, it can open doors to opportunities such as homeownership, education and financial flexibility. Mismanaged, it can weigh you down and derail your finances. The key is to approach debt as a tool -- one that, when used responsibly, can help you build wealth and strengthen your financial future.
Approach debt with caution, respect and a plan, and you'll ensure it works for you -- not against you.
Strategies for Managing Debt
Not all debt is created equal. So-called "good debt" can be an investment in your future. Mortgages, student loans and small business loans can fall into this category when managed responsibly. These types of debt typically offer lower interest rates and may offer tax advantages and the potential to create long-term value.
Bad debt, on the other hand, usually refers to high-interest obligations such as credit-card balances or payday loans. This type of debt is best avoided and can quickly spiral out of control if not paid off in a timely manner, quickly eroding your financial health.
Following the herd may not make sense when it comes to managing debt. As of the end of last October, TransUnion reported that the average American consumer carried more than $6,000 in credit-card debt, with an average annual percentage rate (APR) hovering over 20%. That's a problem. It's a costly burden and a clear indicator that a lot of folks aren't using credit responsibly.
Buck that trend with these four moves:
1. Borrow Only What You Can Comfortably Afford to Repay
Before taking on any debt, be sure it will fit into what I'll call your "cash-flow comfort zone." In other words, will making timely payments be an issue? You can calculate your debt-to-income (DTI) ratio to try to figure that out. Your DTI ratio compares your total monthly debt payments to your monthly income. A DTI below 36% is generally considered healthy, but remember, no one knows your money situation like you do. A DTI calculation may not capture the true essence of your capability to make those payments. For example, perhaps you're supporting adult children through a difficult time. Something like that won't show up in a DTI calculation, but it could affect your ability to make payments.
Actionable tip: Use a loan calculator to determine how much you can comfortably borrow without jeopardizing other financial goals.
2. Pay More Than the Minimum
Minimum payments may keep creditors off your back, but they do little to tackle principal balances -- especially on high-interest debt rates. Paying extra each month not only lets you knock out that debt faster but saves you significant money in interest.
Actionable tip: Paying an additional $50 a month on a $5,000 credit-card balance with a 20% APR can shave years off your repayment schedule and save thousands in interest.
3. Prioritize High-Interest Debt
Use the avalanche method, which means paying off debts with the highest interest rates first while making minimum payments on others. This strategy minimizes overall interest costs and helps you achieve financial freedom faster. In the current interest-rate environment, this is critical. Alternatively, the snowball method focuses on paying off the smallest debts first for psychological wins. Choose the approach that motivates you most.
Actionable tip: Map out your prioritized payment plan with a specific "time to completion" on each debt.
4. Don't Let a Points Race Get You Sidetracked
Travel or rewards points are part of credit-card issuers' marketing budget for a reason: They inspire us to use the card. And while there's nothing wrong with taking advantage of these programs -- we do at our house -- don't let the quest for the next trip or reward cause you to lose sight of what's critically important: your financial wellness. Use the programs to enhance your life in the context of being financially responsible.
Actionable tip: Find a program that works best for you and use it in the context of your planned spending; don't stretch your budget to earn additional points.
Building and Maintaining a Strong Credit Score
Your credit score is your financial report card or lender reliability report. How you manage credit influences your ability to borrow money and at what rate, your ability to secure housing and, in some states, your insurance rates. It even contributes to your ability to land certain jobs.
What Makes Up a Credit Score?
Credit scores take into account different aspects of your credit use. FICO credit scores, for example, ranging from 300 to 850, are determined by five main factors, presented with actionable tips:
- Payment history: 35%. Pay bills on time, every time. Even one missed payment can lower your score by up to 100 points.
- Credit utilization: 30%. Keep your credit card balances below 30% of your total credit limit. Lower is even better.
- Credit history length: 15%. The longer your accounts have been open, the better. Avoid closing old credit cards unless absolutely necessary.
- Credit mix: 10%. A variety of credit types -- such as a mix of credit cards, auto loans, and mortgages -- can improve your score.
- New credit inquiries: (10%). Limit how often you apply for new credit, as hard inquiries can temporarily lower your score.
Practical Steps for Military Families
Here's how military households can build a strong credit score:
Interest rate cap. Military families receive unique financial advantages, including provisions in the Servicemembers Civil Relief Act. The SCRA caps interest rates on pre-service debts at 6% during active duty. Use these benefits to manage debt more effectively and build financial resilience.
Keep tabs on your situation and the market. Use resources such as AnnualCreditReport.com to monitor your credit and ensure there are no errors dragging down your score. With interest rates on the rise, borrowing costs are higher than they've been in years. If you're considering taking on new debt, shop around for the best rates and terms.
Earmark a portion of your pay raise. And if you're part of the military community and fortunate enough to receive a military pay raise (or two!) this year, consider applying a portion to debt repayment.
Debt isn't inherently bad; it's how you use it that matters. By borrowing wisely, prioritizing high-interest balances and building a strong credit score, you can harness the power of debt to achieve your financial goals.
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