6.2: Choosing Loans and Managing Debt Wisely
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If you find yourself in the market for a credit card or loan, take time to fully understand the terms and conditions before you apply. Knowing what the monthly payments will be and ensuring they fit comfortably into your budget also is crucial.
How to Choose a Credit Card or Other Loan
If you’re considering opening a credit card or taking on another loan, such as a car loan or personal line of credit, there are several factors to consider.
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Lender - Before applying for a credit card or loan, research the lender and make sure the company is reputable. To apply for a loan, you’ll likely have to share personal and financial information that you don’t want to end up in the wrong hands.
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APR - The APR, or Annual Percentage Rate, of a credit card or loan is the rate at which interest will accrue on the balance you carry. The APR can be fixed or variable.
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Fixed – The interest rate remains the same during the fixed rate period of the loan
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Variable – The interest rate can change over time, usually fluctuating with the market
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Fees – There are many possible fees you’ll want to be aware of before opening any loan. One of the most common is a late payment fee which is what you’ll be charged if you don’t pay your bill on time. Some credit cards carry other fees you’ll want to be aware of, such as:
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Annual fee - A yearly charge for having an open credit card account
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Cash advance fee - A charge for using your credit card to withdraw cash (i.e. at an ATM)
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Foreign transaction fee - A charge for using your card out of the country
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Balance transfer fee - A charge for moving a balance from one credit card to another
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Benefits - Some lenders may offer consumer perks for those who use their loan products. Examples of this include free credit score monitoring services for borrowers or rental car insurance if the rental is paid for with the corresponding credit card.
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Planned card usage - When looking at credit cards specifically, you’ll want to consider what you’ll use the card for before applying
Using and Managing Debt Responsibly
Having debt can impact your financial life in many ways from needing to make monthly payments to affecting your credit score, which raises the question - is all debt created equal ?
The answer is no. Some debt is commonly considered “good” while other debt is looked upon less favorably. One way to distinguish between these two types is to look at what the debt does for you. Some forms of debt let you achieve your goals, such as attending college or buying a car or home. Other debt keeps you stuck in the past or creates patterns of harmful financial behavior, such as living outside of your means and carrying a high balance on a credit card.
Avoiding “Bad” Debt
Knowing the difference between debt that benefits you and debt that gets in the way can help you plan your finances and set goals. Knowing what you can do to avoid bad debt can also help you as you work toward achieving financial success.
Here’s what to pay attention to and do to keep bad debt out of your life:
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Create a budget. The first step to avoiding bad debt is knowing what you can and can’t afford each month. Calculate how much you earn monthly, then subtract your fixed expenses from your income to see if you have any discretionary income.
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Fixed expenses - expenses that stay the same and do not vary from month to month (car loan, mortgage payment, rent payment, etc.).
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Variable expenses - expenses that change over time (electric bill, dining out expenses, credit card payments, etc.).
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Build up an emergency fund . Payday lenders promise that they’ll help you out in a pinch. But their “help” is super expensive, due to high interest and fees, and can make a tough situation even more challenging. If you can save up an emergency fund , even just a few hundred dollars, you have something to fall back on when money is tight.
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Be cautious of interest rates . How much you pay in interest can make a good debt bad or a bad debt even worse. Shop around when looking for loans or credit cards to get the lowest rate possible.
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Consider the value the loan provides . Before you borrow money, consider the long-term value of the loan. With a mortgage, you may be spending hundreds of thousands of dollars, but you end up with a forever home. In terms of student loan debt , you might not be able to pursue your desired career without borrowing money. With credit card debt, not being able to pay off the entire amount you borrow right away can end up costing you even more without any real benefits for you.
- Try to keep your overall debt low . Lenders often talk about the debt-to-income ratio. That ration is how much you pay each month compared to your income. The lower your debt-to-income ratio, the more financially comfortable you can be. If you have a lot of debt already, whether it’s good debt or bad debt, it’s a good idea to consider how taking on an additional loan would add to your debt-to-income ratio. If your ratio is over 43 % , paying off debt can be challenging.
Paying Down Debt
Typically, one of the best ways to eliminate debt is to make more than the minimum payment whenever you can. Even adding a small amount to your required payment each month can make a big difference.
The example below demonstrates how adding to your minimum payment each month can help you not only pay off a credit card balance sooner, but also save money on interest over time.
Debt Repayment Strategies
How you tackle your debt repayment should be based on your specific situation. Two common options are the debt avalanche and debt snowball methods .
The debt avalanche method has you focus on paying off the loan with the highest interest rate first – just like how an avalanche starts at the peak and tumbles downward. This method allows you to save the most money on interest in the long run. Here’s how the debt avalanche works:
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List all your debts from highest interest rate to lowest interest rate without listing the balances.
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Make the required minimum payment on all debts
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Put any extra money toward the debt with the highest interest rate.
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Once the highest interest rate debt is paid off, take that former payment, as well as any extra money, and apply it to the next highest interest rate debt.
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Continue until all debts are paid off.
The debt snowball method has you focus on paying down your smallest debts first and then work to eliminate larger ones – just as a snowball starts small and gets bigger and bigger. While you won’t save you as much in interest payments, the quick wins of eliminating payments can help you stay motivated to continue. Here’s how the debt snowball works:
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List all your debts in order from lowest to highest balance without listing interest rates.
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Make the required minimum payment on all debts.
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Put any extra money toward the debt with the lowest balance owed.
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Once the lowest balance debt is paid off, apply that payment and any extra money to the next lowest balance debt.
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Continue until all debts are paid off.
If you’re concerned about a high balance on one account, you might focus on that debt first, even if that account isn’t your smallest loan or highest interest debt.