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6.2: Choosing Loans and Managing Debt Wisely

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    110118
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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.

    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:

    • 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.

    Chart Showing Impact of Minimum Payments on Interest Accrual

    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:

    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:

    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.


    This page titled 6.2: Choosing Loans and Managing Debt Wisely is shared under a CC BY license and was authored, remixed, and/or curated by Heather Burns, Connie Ogle, & Allyson Valentine.

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