The Key to Effective Debt Management
How to manage debt effectively on your own and how to recognize when it’s time to seek professional credit help
Effective debt management begins with the ability to prioritize debt repayment within the limitations of your budget. You must be able to organize your debts and set up a payment schedule that allows you to avoid defaults. The goal is always to get out of debt as quickly as possible, while minimizing interest charges. This usually means that you put debts with the highest interest rates first, since they cost you more over time.
This guide is designed to help you craft a personal debt management plan so you can reach zero faster. If you have questions or need help, we encourage you to reach out to talk to a credit counsellor. They can help you identify debt relief solutions that you may not know about.
The key to managing debt
Effective debt management is always about one thing: balance. If you balance debt payments against your income, you can afford to make the payments without juggling other expenses. When you take on too much debt for your income, this is when money starts to get tight.
So, first you need to see where you stand, overall. You do this by checking your debt-to-income ratio. This measures your monthly debt payments versus your monthly income. It’s the same ratio that lenders check during underwriting when you apply for a new loan. They only approve you if your debt-to-income (DTI) ratio is 41% or less. Most experts recommend that you should keep your ratio below 36% so you have some room to maneuver.
If your debt-to-income ratio is higher than 41%, it’s probably due to credit card debt. When you open a new credit card DIT is not a qualification factor – approval depends on your credit score. As a result, you can open a credit card and run up debt, leading to a higher debt load than that 41%.
If run the numbers above and your ratio is more than 50%, then you it’s likely that you will need professional debt help. You may be able to solve your challenges on your own, but it will take a carefully crafted repayment plan. You will also need substantial free cash flow in your budget. If you’re barely making ends meet, then it may be impossible without professional assistance.
How to prioritize debt for repayment
If you have a range of different types of debt, the first thing you need to do is prioritize them for repayment. This typically means arranging your debts by interest rate, starting with the debts that have the highest APR first. Thus, credit card debt often gets prioritized first, because revolving debts typically have much higher rates than installment debts, like loans.
That’s not to say that other debts can’t take priority. Let’s say, for instance, that you owe back taxes to the IRS because you didn’t pay income taxes. Tax debt can have penalty APR up to 25%, which can stack up quickly, depending on how much you owe. This type of debt can also be extremely debilitating. If you don’t pay it, the IRS can garnish your wages, place levies on bank accounts and liens on property. So, in this case, you might choose to prioritize tax debt first.
In most cases, your mortgage goes at the bottom of the list. Mortgages tend to have the lowest interest rates and take the longest to pay back. So, you don’t try to pay it off until you’ve eliminated everything else. Student loans also tend to go below credit cards. The interest rates are low, by comparison. You also have options like deferment and forbearance that can reduce or suspend your payments for a limited time. These options allow you to focus on paying off other debts, until you have the funds to eliminate them quickly.
Managing debt for faster elimination
Once you have your debts organized, it’s time to craft a debt management plan that helps you reach zero quickly. This involves organizing your budget so you can focus as much cash as possible on each debt successively.
- Review your budget to cut back on as many expenses as possible so you can maximize free cash flow.
- Make all required debt payments on time.
- Focus all your extra cash on making larger or extra payments on the debt you want to eliminate first.
- Once that debt is gone, roll the money you save on that bill into the free cash flow you will use for the next debt.
- This allows you to gain momentum as you pay off debt, so you can eliminate the next debt on your list even faster.
5 Tips for Effective Debt Management
#1: Be careful about cutting your budget back too far
A crash debt elimination plan has the potential to fail as easily as a crash diet. If you cut everything fun out of your budget and scale back to just the bare bones, it will definitely maximize your free cash flow. But it also puts you at risk of overspending once you get tired of living on a shoestring budget. It’s like a financial binge after months of financially starving yourself.
Your debt management strategy is more likely to work if you can maintain it over time. So, leave a few discretionary expenses in your budget so you can enjoy life and unwind. Otherwise, you may take a shopping spree in a few months that will set you back further from your goal.
#2: Set up a financial safety net at the same time
If you have excessive debt, it’s probably eating up every dollar out of your paychecks before they clear your account. This means you probably don’t have money in savings, which puts you at high risk for taking on more debt. Essentially, if any emergency or unexpected expense happens, you won’t be able to cover it. That means it’s likely to go on a high interest rate credit card.
So, once you get into your debt management plan, start diverting some of the money you save into your savings. Instead of taking all your free cash to pay off as much debt as possible, divert a little into savings. This way, if something comes up, you can cover it with cash instead of credit.
Ideally you want to save about 5-10% of each paycheck you bring in. But before you get to that, even 1-2% can start to build your financial safety net.
#3: Find ways to reduce or eliminate interest charges
Interest charges always make it harder to pay off debt. They eat up a portion of each payment you make. The higher the APR and interest charges, the less principal you pay off (that’s the original debt you owe). So, by reducing or eliminating interest charges, you accelerate debt repayment.
There are a few ways to minimize interest charges:
- For a loan, you can refinance the debt at a lower interest rate
- On a credit card, you can call the creditor to negotiate a rate reduction
- You can convert a debt to a different type of debt at a lowest interest rate, like using a debt consolidation loan.
- You can enroll in a repayment plan that offers reduced interest rates
The more you can lower the rates applied to your outstanding debt, the less they will cost overall. You save time and money by reducing your rates before you focus on debt elimination.
#4: Don’t miss payments
Even though most of your energy and cash flow gets devoted to one debt at a time, don’t let the others slip. If you miss any payments, it creates negative remarks in your credit report that stick around for seven years. These remarks hurt your credit score, which can make it harder to qualify for debt relief options, such as consolidation.
Always try to make at least the required minimum payments on all your obligations. If you see that you may miss a payment, call the creditor; not after you miss the payment, but before. Creditors are usually more willing to work with you if you call them ahead of time. They may allow you to pay late without penalties or make a reduced payment. You won’t know until you ask. If they agree to adjust or suspend your payment schedule, make sure to keep up your side of the bargain. It doesn’t look good to creditors if they try and work with you and then you let the deal fall through.
Keep in mind that once you miss a payment, the creditor may also increase interest charges and add penalties. These new charges just stack up on the debt that you already owe, making it harder to reach zero. Make every effort you can to keep payments current to avoid additional charges and credit damage.
#5: Don’t be intimidated into inaction
One of the problems with debt problems is that most people don’t know about potential solutions until they need them. Most people never received any formal education about personal finance and much understanding comes from word of mouth. So, you don’t hear about something like debt consolidation until you are already deep into debt.
This, combined with a desire to solve financial problems without outside help, can lead to severe procrastination. You keep making payments without making any real progress because you don’t know what else to do.
However, allowing a debt problem to linger usually only makes it worse. It also gives you time to damage your credit score. More debt and lower credit will make it even harder to reach zero. So, you can’t let fear, intimidation or a desire to fix things on your own delay your plans for debt relief.
Start looking for a solution as soon as you start to struggle. Don’t hide from your creditors. Instead, talk to them and see if you can work something out. And always keep in mind that no solution is set in stone. If you try one option for debt relief and it doesn’t work, you can always try another.