The Inside Skinny On Debt: 2 Strategies to Pay Off Debt
Americans are drowning in debt. The consequences can be dire.
According to the Federal Reserve Bank of New York, the total amount of household debt reached a stunning $16.51 trillion in the third quarter of 2022. Mortgage balances accounted for $11.67 trillion of that amount.
The average American carried a consumer debt of $96,371 at the end of 2021. This total includes mortgages, lines of credit, student loans, auto loans, credit cards, and personal loans.
Credit card debt has been exacerbated by inflation. In fact, one study found that 35% of U.S. adults carry credit card debt. This debt is especially harmful because of high-interest rates. As of January 4, 2023, average interest rates were almost 20%.
Americans are often uninformed of these high-interest rates. One survey found 43% of those paying interest on their credit cards were unaware of the amount of interest being charged.
How much debt is okay?
What’s a reasonable amount of debt to carry? Much depends on your situation and the type of debt at issue.
According to the Federal Housing Association, which provides underwriting guidelines for FHA mortgage loans, your total mortgage payment and debt should not exceed 43% of your “gross effective income.”
Good debt
Not all debt is bad. Taking out a mortgage permits you to buy a home and pay it off over time. Securing shelter for you and your family is a sound reason for incurring debt.
Buying a car is essential for many who require transportation for commuting to work and running their daily lives. An automobile loan is often necessary and prudent. When taking out an automobile loan, it’s important to consider the downside. Cars depreciate quickly. The longer the loan term, the more interest you’ll pay.
You can mitigate these downsides by not buying a more expensive car than you need, making as large a down payment as you can afford, and keeping the term of the loan as short as possible.
Student loan debt is an investment in your future. A better education may lead to a better job and a higher quality of life.
You may need to incur debt if you want to start your own business to fund initial and ongoing costs. The U.S. Small Business Administration can help you get an SBA-backed loan at competitive rates and fees.
Bad debt
Debt that carries a high-interest charge is generally considered “bad debt.” Bad debt includes credit cards and high-interest personal loans.
Some debt is so terrible that calling it “bad” is an understatement. Payday loans fit squarely into this category. These are short-term loans of relatively small amounts and are often the last resource for emergencies.
The interest rates on these loans are obscene – and should be illegal in all states. According to the Center for Responsible Lending, in some states like Texas, Utah, and Nevada, the annual interest rates on a $300 loan can be more than 600%! Other states have enacted legislation to prevent this predatory lending.
How to pay off debt?
Getting out of debt is a worthy goal. If your total debt is crushing your finances, or you are carrying bad debt, it’s time to formulate strategies to pay off debt.
Two common ways for paying off debt are the debt snowball and debt avalanche strategies.
The debt snowball method involves paying off the smallest debt first after you pay the minimum required on all outstanding balances.
The debt avalanche method starts by paying off debt with the highest interest after you make minimum payments on your other debt.
Both methods are effective, but neither is a quick fix. Depending on the amount and interest, eliminating your bad debt can take four to six years.
You might also consider consolidating your debts into one obligation with a lower interest rate. If so, you need to explore a debt consolidation loan, where you borrow sufficient funds to pay off your high-interest debt and make fixed monthly payments until the loan is paid off, typically in two to four years.
You can explore the benefits of a debt consolidation loan and find a list of lenders here.
If you need assistance, a financial advisor can help devise a plan to get you out of debt. Look for one who is a Certified Public Accountant (CPA), certified financial planner (CFP®), or chartered financial analyst (CFA®).
The earlier you start getting out of debt, the quicker you’ll be on the road to securing your financial future.
Darrell Armuth founded Sensible in 1994. Since then, he has served hundreds of clients. Darrell is a Certified Public Accountant certified by the state of Nevada.
