We all have good intentions when we open up our first lines of credit or take out those student loans. We’re sure that we will never become one of those people–the people who find themselves mired in five figures worth of debt and only a middling income with which to make ends meet. Unfortunately, what most of us don’t realize is that this type of debt rarely happens quickly. Instead it builds slowly over time–a missed payment here or there, a medical emergency, etc.
Finding oneself in extreme debt is uncomfortably common in today’s “buy now, pay later” culture. We are all sure that we will earn more money in the future to pay off whatever it is we’re impulse buying now. For most of us, though, all that happens is that we build up a mountain of debt. A mountain that we can do little more than chip away at a tiny bit at a time.
Good Debt Vs. Bad Debt
Of course, not all mountainous debts are bad. A mortgage, for example (if you pay your bills on time every month) is considered good debt because it builds equity. A car loan is a less expensive example of this same idea. Even student loans–if you can manage your monthly payments–work this way. These debts, if you pay your bills on time, prove that you can handle your bills and can help you build a good credit score.
Bad debt is everything else. Credit card debt, personal loans, bills that have gone to collections, etc. These types of debt are considered bad because they don’t add to your personal net worth and, if you rack up enough of it, show future creditors, lenders, landlords, etc. that you don’t know how to handle your money responsibly. It lowers your credit score and borrowing ability, sometimes killing it off completely.
Debt to Income Ratio
Another factor, especially where your credit score is concerned, is your debt to income ratio. If you’re earning six or seven figures a year, a five figure level of debt is a much smaller deal than if your income is only in the five figures.
According to the Consumer Finance Protection Bureau, it is important that you never let your debt to income ratio exceed 43%. When it gets higher than this, your ability to make even minimum payments on that debt, let alone pay it off completely, is dramatically reduced.
Dealing With Debt: A 4-Step Program
Before you can begin to really tackle your debt, you need to find out how much you actually owe and to whom you owe it. The best way to do this is to get a current copy of your credit report. It will list all of your accounts and their standings (as well as contact information so you can get current statements from creditors and lenders and work out payment plans with them).
Setting Up a Budget
If you’ve never lived with a budget before, don’t panic. It’s easier than it seems. Setting up a monthly budget is the best way to ensure that you don’t overspend. For the total newbie, the best way to get used to living within your budgetary restrictions is to use the envelope method (there are apps you can use to do this digitally if you don’t want to keep cash around).
When you start putting together your budget and your debt reduction plan, you might only be able to make the minimum payments due to each account. That’s okay! What’s important is that you start paying on time every month to help build up a positive payment history. In a few months you can increase the amount you pay on each account so that you’re actually paying down your debt instead of just paying off the interest.
It’s also important to take a good hard look at what you’re spending and where you’re spending it. You will be surprised at how many different ways there are to reduce what you spend without making yourself feel deprived of the lifestyle you enjoy.
Increasing Your Income
If you really want to be serious about paying off your debt (and saving for the future, which is also important), you should consider looking for ways to bring in more money as well as ways to spend less. There are plenty of “side hustles” you can do that won’t detract from your current day job.
Over time, if you follow this plan, you should see your mountain of debt start to shrink and your credit score improve. It will feel good to be financially responsible, we promise!