Debt, also known as consumer debt, is what you owe based on the money you borrowed from a credit union, bank, the federal government, or other lending entity. At some point in nearly everyone’s life, there will come a time when you’ll need to take on debt or use credit or credit cards. Whether it’s for a student loan or personal loan, a mortgage or auto loan, taking on some kind of debt is almost inevitable.
Having debt is completely normal — but it can easily become too much to handle if you’re not making the minimum monthly payment or don’t have a debt management plan in place. If you fall into that category, take a deep breath — you have options to get back on track. Ahead, we’ll walk you through the basics (and effects) of debt and share our 6 best tips for debt payoff.
What are the different types of debt?
There are two types of debt:
Revolving debt: the most common example of revolving debt is credit card debt. For this type of debt, you have an amount (or limit) that you can borrow up to, called a credit limit. When you pay this debt down, you can borrow it again. The line of credit does not go away once the balance has been paid off.
Non-revolving debt: this debt is what most of us think of as a loan. You pay this type of debt off monthly with a corresponding fixed or variable interest rate. Some common examples that you might currently have: an auto loan, student loan, mortgage, and emergency loan.
As of January 2018, consumer debt in America rose 4.3 percent, totaling $3.855 trillion. Of that amount, $2.8 trillion is non-revolving debt (think: your student loan).
How does debt affect your credit score?
As you can probably guess, carrying a lot of debt (especially credit card debt), can hurt your FICO score and your ability to take out other lines of credit, like a new credit card, loan, or even just increasing your current credit limit.
Your level of debt is 30% of your credit score. This percentage takes your credit utilization into account, which is the amount of credit you have used in relation to your total combined credit limit. It’s important to keep this number as low as possible, as it is a proxy of how well you are handling your debt.
Your credit score also takes into account your ability to handle paying off debt. If you’re paying more than the minimum payments every month, chances are your credit score will slowly improve over time. This will signal to future creditors and credit bureaus that you’re a responsible borrower. If you’re not making the minimum payment, chances are your credit score will continue to stay low — and even fall.
One other way that debt affects your credit score is by having multiple lines of credit. Having a mix of credit can help your credit score — if you’re making your monthly payments on time at the minimum (or paying more!), you’re in good shape. Set up autopay or a calendar reminder, though — just one late payment can set this good track record back and lower your score.
Here’s a breakdown of how credit scores are calculated:
35%: your payment history
30%: amounts owed
15%: length of credit history
10%: new credit
10%: credit mix
If you’d like to keep up with your credit score, every American is entitled to a free credit report from each major credit bureau (there are three: Equifax, Experian, and TransUnion) every 12 months. You can request your free credit report here.
Is there such thing as good debt and bad debt?
Depending on your preferences and financial views, there is an argument to be made that no debt is good debt. But in most cases, taking on mortgage debt is one of the only ways a household can afford to purchase those big and important items like a home. And in many cases, your home will build value over time, which could mean a big profit when it’s time to move again.
Generally speaking, if you can get a return on your investment, it’s a good debt to have. This would include your federal loans or private student loans for your education, investing in your own business, as well as your home or other real estate.
And while sometimes it is essential, your auto loan or consumer debt is on items that almost always depreciate. If we’re pointing fingers, this would be considered bad debt — and it can stack up if you’re not careful.
How much debt is normal?
Debt is personal — the “normal” or average debt amount will vary from person to person, because it all depends on your liabilities, or the debt you owe. Some college graduates come out debt-free without student loan debt to repay, but most aren’t so lucky. Some individuals have to rely on credit cards to pay medical debt or various bills, while others take on car loans and other debt. All in all, the average American has about $38,000 in personal debt, but this excludes mortgage debt. Of that amount, the average credit card debt per American is about $6,194.
But how much debt is normal? If you’re looking for a hard number, a good rule of thumb to calculate a normal debt load is the 28/36 rule. This means that you should spend no more than 28% of your income on home-related expenses, like mortgage payments, property taxes, rent, and the like. On the other hand, all other debt repayments (meaning your monthly minimum payments) outside of your home expenses should not exceed 36% of your income. If you find that 40% or more of your income is going toward paying off your debt each month, chances are you might have taken on too much — but here are 6 debt repayment tips to help you get out of the red zone and into a more comfortable threshold.
The 6 tips to paying off debt
Regardless of the types of debt you have, one thing is for sure: you owe someone a sum of money and you need to pay it to avoid consequences in the future (like a low credit score). Here are 6 tips we recommend trying out as you pay off debt.
1. Make a list of ALL of your debts.
This is the first step you need to do as you pay off debt. You need to know how much you owe to each lender, including the interest rate and maturity date of the loan. Be specific since this will guide you in getting out of debt.
Make sure that you list everything, regardless of the amount of money. This will give you a better idea of your financial standing and make it easier for you to decide how to pay them, which leads you to the next tip.
2. Strategize repayment of your debts.
Now that you know how much money you owe, the next step is to come up with a debt relief strategy. Here are two different ways.
The first strategy is called the debt avalanche method. Ideally, you can pay off the loan that charges the highest interest rate first, as these are the most "expensive" lines of credit. This technique will allow you to save more and make it easier for you to pay other loans since the money you use to pay interest is reduced.
A second strategy is to pay the loan with the earliest maturity date to avoid incurring penalties. If you want to reduce the number of debts, then pay off the loan with the smallest outstanding balance first. This is called the debt snowball method.
3. Negotiate your loan terms.
This is another easier and convenient way to pay off debt — and it can bring some serious debt relief. Negotiate for a lower interest rate or longer payment terms to help you pay your financial obligations off with less stress (and potentially at a faster rate).
If you have several loans under a single creditor, then try consolidating them so you don’t have to worry about multiple rates and due dates. You can also suggest other terms such as a bi-weekly payment plan or waiving of the termination fee in case of early repayment.
Nonetheless, debt consolidation will be possible if you have a good relationship with your creditor or credit bureau. A good payment history and account standing give you a better chance of negotiating your loans to save more. It is always in the bank's interest to have you pay the debt. Bankruptcy or foreclosures cost the banks more money.
4. Use your savings to pay off loans.
The age-old question: should you save for an emergency or pay off debt first? If you have a separate account for savings or an emergency fund (or even if you don’t), you might be wondering the best way to tackle your debt payoff. If your debt is mounting and you have aggressive rates of interest, then perhaps now is the best time to use it — this will prevent you from incurring ballooning debt. You might be uncomfortable at first. However, using your savings to pay existing financial obligations will also make it easier for you to set aside money for future use.
Still, don’t use your entire savings to pay off debt. Focus on loans with the highest interest rate. Paying them off first creates a big dent on your financial standing, thereby minimizing your loans.
(And in case you are not comfortable using your savings, you can try the next tip.)
5. Look for extra job(s) for additional income.
Side hustle opportunities are everywhere. It’s just a matter of finding the right one for you. Look around for opportunities that enable you to earn extra money to repay your personal loan, student debt, or other debt faster without taking money away from savings.
You can try the following:
Hold a garage sale and sell items you no longer need but can be useful for other people. You can also sell them online through eBay, Craigslist, Facebook Marketplace, or on the Nextdoor app.
Get into freelancing that matches your skills and/or interests.
Apply for a part-time job.
The money you earn may not pay the entire loan, but this could be helpful in reducing your debt. Take advantage of it.
6. Use your bonuses wisely.
If you receive a tax refund or bonus from your employer for good performance, what will you do with the money?
Shopping or eating out with the family can be a fun option. If you want to be wiser, you could use the extra money you have to pay for your existing financial obligations. When you do, you will be able to reduce the principal amount of your loan and minimize the corresponding interest as well. It’s a sacrifice on your part, but a sacrifice that’s worth it because you minimize your chances of swimming in a pool of debt.
When it comes to your debt payment, your main financial goal should be to take it one step at a time to avoid bankruptcy and other financial stressors. Repaying your loans doesn’t happen overnight, but always remember that every (on time) payment matters.