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Dealing with Debt
What is Debt?
When you borrow money from your credit union, bank, or other types of creditors, you incur debt which is the total amount of money you borrowed and are expected to pay back. In most cases, you will also be charged interest which is an additional cost paid to lenders for borrowing their money.
Not all debt is bad. Good debt, such as low-interest loans for education, a home, or a car, can help you achieve your financial goals. On the other hand, bad debt may be costly and sideline you from reaching your goals. Having high-interest rate credit cards, overspending, or not paying your debts on time can lead to paying more for items that may not hold long-term value. Managing debt responsibly can help you establish and maintain a positive credit history. A key metric for determining how much debt to carry is your Debt-to-Income (DTI) ratio, which shows the percentage of your gross income that goes towards your monthly debt payments. Lenders use this ratio to assess how risky it is to lend to you.
How Can I Tackle Debt?
Debt can feel overwhelming, but with the right strategy, you can manage and reduce the financial burden and take control of your financial situation. Start by assessing your current situation. For a clear picture, make a list of your outstanding debts, including the interest rate or Annual Percentage Rate and a payment schedule for each debt. Next, create a budget that outlines your income and expenses. Lastly, adjust your expenses to find extra money to devote to debt reduction. Seeking additional income sources can also expedite the repayment process. Remember, managing debt is a gradual process. With determination and budget planning, you can work towards a more secure financial future.
Learn More
Fair Debt Collection Practices Act
It is important to remember that every debt must be repaid. The Fair Debt Collection Practices Act (FDCPA) is the main federal law that governs debt collection practices. The FDCPA prohibits debt collection companies from using abusive, unfair or deceptive practices to collect past due debts from you. Visit the CFPB for more information regarding FDCPA.
Frequently Asked Questions
- Add Up Monthly Debt Payments: Include all your monthly debt obligations such as your: mortgage or rent payments; student, auto, and personal loans; other loans; credit card payments, child support payments that you make; alimony payments that you make; and any other monthly debt payments. Living expenses such as utility bills, food, and entertainment are not typically included.
- Add Up Gross Monthly Income: Your gross monthly income includes the total amount of money you receive in a month from all sources before taxes and other deductions. Income includes earnings from your employment as well as other sources.
- Divide and Multiply: Divide your total monthly debt payment by your gross monthly income then multiply by 100 to get a percentage.
Example: If your total monthly debt payments are $1,500 and your gross monthly income is $5,000, your DTI is 30%. This means that 30% of your gross monthly income goes towards paying debt. Knowing your DTI is important for keeping track of your budget. Lenders may also look at DTIs to assess a borrower’s credit worthiness.
Paying only the minimum payment on a credit card often doesn’t significantly decrease the amount due because of the way interest and fees are applied. Here are the main reasons.
- Interest Accumulation – When you make only the minimum payment, a large portion of that payments goes toward interest rather than the principal balance. This means the actual debt amount decreases very slowly.
- Fees – If your account has any fees, such as late payment fees or annual fees, these can add to your balance. Paying only the minimum may not cover these fees causing your balance to remain high or even increase.
- High Interest Rates – Credit cards often have high interest rates. Even if you make the minimum payment, the interest charged on the remaining balance can be substantial, offsetting the reduction in the principal.
- Continued Spending – If you continue to use the credit card while making only minimum payments, new charges will add to your balance, making it difficult to see a decrease.
Example: If you have a balance of $1,000 with an interest rate of 13% and make a minimum payment of 2% ($20), a significant portion of that $20 will go toward interest, leaving a small amount to reduce the principal.
Debt consolidation is a way to combine all of your debts into a single loan with one monthly payment. A debt consolidation loan can offer several benefits, particularly if you struggle to manage multiple debts with varying interest rates and payment schedules. Here are some key advantages.
- Single Monthly Payment – Instead of juggling multiple payments to different creditors, you make just one monthly payment to the consolidation loan provider.
- Lower Interest Rates – If your consolidation loan has a lower interest rate than your current debts, you can save on interest over time.
- Fixed Repayment Schedule – Most debt consolidation loans come with fixed terms, so you know exactly how much you need to pay each month and when you have paid your debts in full. Also, you can pay off your debt faster than you would by continuing to make minimum payments on multiple accounts.
- Improved Credit Score – Using the loan to pay off credit card balances and reduce your credit utilization ratio can positively impact your credit score.
- Reduce Stress – Handling multiple debts can be overwhelming. Consolidating them into one loan reduces the number of accounts you need to keep track of, helping to ease financial anxiety.
- Better Financial Management – A debt consolidation loan can provide a clearer path to becoming debt-free, as you will have a defined repayment plan and a specific timeline for paying off your debt.