Many of us carry some amount of debt – whether a car loan, mortgage or student loans. The average American has just over $104,200 in debt, including mortgages, student loans, credit cards, auto loans, personal loans and home equity loans, according to data compiled from Business Insider. That’s an increase of 3.4% from the previous year’s data.
So, while debt is common, it doesn’t have to become a way of life, especially if your debt levels are preventing you from achieving your financial goals.
How much debt is too much? Your debt-to-income (DTI) ratio, which measures your gross monthly income against your debt obligations, provides one gauge. Lenders use DTI to determine eligibility for mortgages and home equity loans and tend to decline borrowers with a DTI of more than 43%, meaning that more than 43% of their monthly gross income goes to debt payments.
Another widely used metric by lenders is the 28/36 rule, which states that housing expenses should take up no more than 28% of your gross monthly income and that total debt (including housing) should not exceed 36% of your gross monthly income. The rule is more of a guideline, but consumers can use it to ensure they are not taking on more housing debt than they can afford.
Experts say other signs of being overburdened by debt include rising credit card balances, an inability to save money, only being able to afford the minimum payments on debt and using cash advances or borrowing money from other sources to cover debt.
The good news is that with discipline, there are ways to reduce debt or even eliminate it. Here are six strategies to tackle your debt, with tips to help you decide which approach might be right for you.
- Budgeting. Building a budget requires you to track your income against all your expenses, to better understand where your money is going. As part of that process, you should categorize your spending as discretionary and non-discretionary (to see where you might be able to make cuts) and divide your debts into secured and unsecured, to see how your obligations are structured.
Secured debt includes mortgages, auto loans or home equity loans that use an asset like your home or car as collateral. Unsecured debt isn’t backed by collateral and includes debts like credit card bills, student loans, personal loans and medical debt. Understanding the differences between the two can help you decide which types of debt to prioritize and which method to use. Two options include the avalanche method, which involves paying off debt with the highest interest rate first; or the snowball approach, which recommends paying off the debt with the smallest balance first to make faster progress, while making minimum payments on all other debts. Remember, most experts advise paying off any accounts that are delinquent or in collections first. - Personal loan (“debt consolidation” loan). A personal loan may allow you to decrease your debt by reducing the amount of money you pay in interest charges. The idea is to take out a new loan with a lower interest rate than you have on your credit card(s), use the proceeds to pay off the high-interest credit card debt, and then have just the one payment each month at the lower rate. Interest rates can vary widely and are generally dependent on your credit profile and scores.
- Balance transfer. These credit cards, with a low or zero interest rate, are usually available only to those with very good credit. The low promotional interest rate will expire, often in six to 12 months, though many are available for longer terms. Be forewarned: You MUST be able to pay off the balance in full BEFORE that promotional period ends, or the rate will skyrocket, and the transfer will not be worthwhile. In addition, fees can be high.
- Debt resolution (settlement). If you have endured a financial hardship – job loss, unexpected major medical expenses or loss of a loved one – and are having a very difficult time making even minimum payments as a result, debt resolution could be a viable option. Companies offering debt resolution services negotiate on consumers’ behalf with their creditors to lower principal balances due. Repayment terms typically are better than those in Chapter 13 bankruptcy filings, and often are lower than the payments in a debt management plan. Debt settlement companies typically charge a fee based on a percentage (usually a minimum of 15%) of the total debt owed.
- Debt management plan. If you’re primarily interested in paying off unsecured debt, a debt management plan could be worth considering. Debt management plans are offered by credit counseling agencies, who work with credit card issuers to lower the interest rate on your credit cards and create a new payment plan for you. In a debt management plan, you send one payment to the credit counseling agency each month and the agency distributes the funds to your creditors. Debt management plans assess a set-up fee and a monthly fee for each account enrolled.
- Home equity. Homeowners who have accumulated equity in their homes may be able to tap that equity to pay off their debts. There are a variety of ways to access your home equity – from traditional home equity loans to reverse mortgages to home equity agreements (HEAs). Each has their own pros and cons. Reverse mortgages are only available to those 62 and older. Home equity loans typically have lower interest rates than credit cards, but strict income and credit score requirements can make it difficult to qualify. They may also not be a good fit for consumers looking to avoid more monthly payments. Home equity agreements let homeowners obtain cash up front in exchange for a portion of the future value of their home – without a loan. That means there are no additional monthly debt payments. With a lower qualification threshold than loan products (including a balance transfer and personal loan), and no impact to credit score, a home equity agreement can be an effective component of a debt payoff effort.
When it comes to tackling debt, you have options. Carefully weigh the benefits and drawbacks of each approach before choosing the one that best fits your goals.
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