Managing debt is a crucial skill, especially for young adults who often find themselves juggling student loans, credit card balances, car loans, and other large expenses. Whether you find yourself with rising debt or wish to proactively avoid it, developing sound financial habits and strategies can help set you on the path to long-term financial health and stability. If you find yourself saddled with debt or simply have a few bills you would love to pay off, a focused and logical approach can help you get started.
Get the full debt picture.
Knowledge is power, and knowing exactly where you stand is the first step to conquering your debt. Take inventory and make a list of who you owe, what you owe, and the interest rates being charged on your debt.
The interest rates on your debts are crucial. High-interest debt, which we define as debt with an interest rate of 7% or more, can significantly undermine your savings and the growth of your net worth.
For instance, consider a credit card balance with a 15% APR. If you’re investing monthly and generating a 10% annual return, the interest on your credit card effectively negates investment gains on a market value equal to your credit card balance, resulting in a net loss of 5%. In this scenario, prioritizing debt repayment over investment savings is a smart financial move to improve your overall financial health.
This also works in reverse. If you own a home with a 3% mortgage rate, it may be more beneficial to invest any extra cash rather than using it to pay down the principal. If your investments generate an annualized return of 10%, the leverage from your mortgage allows you to achieve a net return of 7%.
Understand your cash flow.
Track your income and expenses and understand your cash flow. How did you accumulate this debt? Were you spending above your means? Ideally, your after-tax income should be allocated by the 50/30/20 rule: 50% to needs, 30% to wants, and 20% to savings or high-interest debt repayment. Are you carrying any high-interest debt? Reevaluate how to deploy surplus cash flow strategically and prioritize debt repayment.
Strategize and tackle your debt.
There are two main methods of tackling debt:
First, the avalanche method focuses on paying off high-interest debt first. You pay the minimum amounts owed on your lower-interest debts and put extra money towards the highest-interest debt. The avalanche method allows you to save the most money in interest over time, though it may take longer to see your progress.
The second, the snowball method, focuses on paying off smaller balance debts first. You pay the minimum amounts owed on your larger balance debts and put extra money towards the smallest balance debt. While this method can help you gain momentum and confidence by eliminating small bills from your debt pile, you may end up paying more interest over time on larger, high-interest balances. But psychologically, this may be the best way for you to make progress by seeing those small wins!
Debt is not always a dirty four-letter word. It can also be a tool for achieving important goals, like buying a home, and creating wealth over time. Also, strategically using debt, such as responsibly managing loans and credit cards, can help establish and improve your credit score over time.
Once you’ve determined which method works best for you, now it’s time to take action and monitor your progress closely. And once you have your debt under control, it’s important to take steps to minimize high-interest debt going forward.
Take Action Now!
- Prioritize tracking your spending and leverage apps such as YNAB and PocketGuard to review regularly.
- Pay credit cards off in full every month.
- Do you own a home? If interest rates fall, consider refinancing your mortgage to pay less in interest.
- Monitor loans with variable interest rates that can go up and down, such as credit cards, HELOCs, some car loans, etc.
- Try to avoid “lifestyle creep.” As your income increases, resist the urge to inflate your lifestyle. Weigh the pros and cons of leveling up with lifestyle upgrades and how critical these purchases are versus saving.