Getting out of Debt

When it comes to debt, the Great Recession will be remembered for the turmoil created in the housing market. But the news doesn't always have to be bad. In fact, the time has never been better to reflect on past spending habits and start a plan to get out of debt.

In this article, we're going to attack consumer debt from three angles, all of which are important in creating a viable, long-term solution for consumers:

Before starting that discussion, we're going to run through a quick primer on good debt versus bad.

Good Debt versus Bad Debt

There is the misconception that all debt is bad, and that's simply not true.  For many Americans, borrowing money is the only way to buy a home or pay for college.  As long as the household has the financial resources to pay back outstanding loans, borrowing money serves a very useful purpose.

Good Debt

The term good debt is usually associated with the purchase of an appreciating asset.  That is to say, money borrowed to pay for things like a new home or to pay for college.  This is an investment in the home or an education, which is expected to be more valuable in the future.

To a lesser extent, good debt can be characterized as secured loans.  These loans are associated with something tangible such as a car.  Admittedly, most cars depreciate over time, but loans on the vehicle are paid off too.  With a collateralize loan, the home or car can be sold to help pay back the money owed if the owner ever runs into financial trouble.

Finally, another good rule of thumb is that good debt is usually associated with a low interest loan that is tax deductible.

Bad Debt

On the other hand, bad debt is usually associated with credit cards or other forms of unsecured loans.  An unsecured loan is one that is not directly backed by an asset, or something tangible that can be quickly sold to pay off the money owed.  Credit card balances are a great example of unsecured loans, and the most economically worrisome source of debt.

With very few exceptions, there is no good reason to carry a credit card balance each month.  If overspending turns into a long-term habit, then it defies the most fundamental of all home economic rules:

Household Expenses must be equal to, or less than, Household Income

Credit Card Bills

The convenience of credit cards oftentimes results in their abuse.  Interest paid on balances is not tax deductible.  Card-issuing companies offer low introductory interest rates, and accountholders may find themselves switching between companies to keep their rates low.

Paying off Bills

It takes discipline to pay off credit card debt, but it's done all the time.  Obviously it's going to mean paying more than the minimum monthly payment.  The below list contains five steps that everyone can take to start that process:

  • Practice Self Discipline:  either stop using credit cards altogether, or start limiting purchases to emergencies or necessities - such as groceries.  Anyone that's tempted to overspend at the shopping mall should cut up their cards and start paying with cash or a debit card.
  • Minimum Payments:  lowering outstanding balances means paying more than the minimum payments each month.  In fact, this website has several loan calculators that can help figure out how long it will take to pay back the money owed.
  • Organize Debt:  it might be disheartening, but it's important to understand how much is owed to creditors.  That means evaluating interest rates charged, as well as the outstanding balance on each card.
  • Prioritize Payments:  the most financially-sound approach is to first pay off credit cards that charge the highest interest rates.  However, people can also get a big motivational boost by first paying off a card or two with relatively low balances.
  • Lower Interest Rates:  finally, sometimes all it takes is a call to the card issuing company to obtain a lower interest rate.  If introductory offers are in the 0 to 8% range, and the company is charging 18 or 20%, then it's time to start negotiating.

Home Equity Loans

Perhaps the single most valuable asset Americans own is their home.  In a robust housing market, many families find themselves with a home worth much more than they paid for it only a short time ago.  They are simply awash in home equity.

Unfortunately, many homeowners begin pulling the equity back out of their homes as quickly as it accumulates.  The outcome is additional debt load, and increased risk of losing the asset backing those loans:  the home.  This is especially worrisome if the housing market slows down.

Negative Equity

A downturn in the housing market can suddenly result in a negative equity situation.  This occurs when the loans using the home as collateral are greater than the home's market value.

Normally, lenders will limit the total of all loans to around 80% of the equity in the home.  But a sharp downturn in values can leave families with very little, or even a negative equity situation.

Floating Interest Rates

Anyone that has floating interest rates (as in the case of adjustable rate mortgages) on their home equity loans might want to consider insulating themselves from future interest rate increases.  This can be accomplished by converting the variable rate loan to a fixed rate mortgage.

Adjustable rate mortgages can be risky in turbulent times.  Locking in a fixed rate mortgage is just another way of demonstrating a commitment to paying off outstanding loans.

Biweekly Mortgage Payments

One way to accelerate the pay down of a loan is by requesting a biweekly payment plan.  With a biweekly mortgage, the borrower will be making the equivalent of 13 monthly payments each year.

A 30-year mortgage, carrying an interest rate of 7%, can be paid off 20% faster with a biweekly loan.  This website has a biweekly mortgage payment calculator than can help the end user run through a series of "what-if" scenarios.

Control Spending with Budgets

Earlier, a simple equation showed how household expenses should never be greater than income, especially in the long run.  To many consumers "budget" is a word that conjures up thoughts of sacrifice, and keeping track of excruciating detail.

The topic of creating a household budget is covered elsewhere on this website, along with downloadable spreadsheets and other aids.  But there are a couple of rules to cover within this topic.

Household Cash Flow

One of the fundamental attributes of a financially healthy household is a positive cash flow.  Cash coming into the home must be greater than cash leaving the home.  If household debt is on the rise, and the reason isn't known, then it's time to build a household budget that gets the home's finances back in balance.

Discretionary versus Mandatory Expense

When creating a budget, one of the activities involves categorizing household expenditures into mandatory versus discretionary expenses.  Mandatory expenses are those people really cannot live without.  For example, this might include paying back loans on a home or car, purchasing food or groceries, buying work clothes, and paying for utilities such as water, natural gas, and electricity.

Discretionary expenses are those that contribute to monthly debt load but don't have a significant impact on the family's quality of life.  Discretionary expenses include costs such as eating out at expensive restaurants, a weekly visit to the spa, or lavish vacations.

Once the household income and mandatory expenses have been identified, a "monthly cushion" is easy to isolate.  This monthly cushion is the money that's left over each month to spend on discretionary items.  Understanding the boundaries of this cushion is a key to getting out of, and staying out of, debt.

About the Author - Getting out of Debt (Last Reviewed on September 21, 2016)