How to Understand Your Debt and It’s CostsApr 15, 2023
Debt is a common aspect of modern life, but it can be difficult to understand the impact it has on your financial health. There several different types of debt. You could have student loans, an auto loan, a mortgage, a personal loan or credit card debt. It’s important to understand what each of these types of debts are costing you so you can make informed decisions about which debt to tackle first. Today, we'll explore how to understand your debt and what it costs you.
Let’s start with a key metric of your financial health, your Debt-to-Income Ratio. To find your debt to income ratio, simply add up all your debt payments and divide it by your monthly income. A good debt-to-income ratio is considered anything below 36%. If it is high, it means you're spending a significant portion of your income on debt payments. That can make it difficult to save money, invest and meet your financial goals.
Let’s talk about the different types of debt.
- Credit Card Debt: Credit cards are very convenient but they can also be a dangerous threat to your financial health unless you pay them off monthly. Credit cards are unsecured debt, which mean there is no collateral. As it is unsecured, the interest rates on credit cards are typically high. Right now the yearly interest rate is around 20.35%. The minimum payment on a credit card is around 2% of the balance and the rest of your payment went to pay interest. What does that all mean? Let’s look at an example:
Let’s say you have $1,000 on a credit card. The average interest rate is 20.35% yearly which compounds daily. Typically, a minimum payment is about 2% of the balance plus the monthly interest charges. So your initial payment would be $37 a month. Of this, $20 pays down your credit card balance and $17 dollars pays the monthly interest. It’s important to note that your minimum payment will go down as the balance drops. As a result, it would take approximately 5 years to pay off a $1,000 credit card balance making only the minimum payments.
- Personal Loans: Personal loans are also unsecured loans that you can be used for any purpose. These typically have fixed repayment terms. This means you will have a fixed monthly payment and a known pay off date if you pay the minimum due monthly.
- Student Loans: Student loans have been all over the news the past couple of years as they have a huge impact on this generations ability to thrive financially. The amount of money required for higher education has been doubling every 9 years. This has resulted in historically high student loan balances. Student loans have various repayment options, and the interest rates are typically lower than credit card debt. Make sure you check into your options. Sometimes it is a good idea to refinance at a lower interest rate. You may also qualify for a loan forgiveness program. There are several companies that can help you check into your options to pay off your student loan debt.
- Auto Loans: Auto loans are used to finance the purchase of a vehicle. They have a fixed repayment term, and the interest rates vary depending on the lender and your credit score. Car loans are secured debt, meaning the lender can repossess the vehicle if you fail to make payments.
- Mortgages: Mortgages are used to finance the purchase of a home. They have a fixed repayment term and interest rates. These loans are secured by the property. There are different types of mortgages. A typical example of a mortgage would be a fixed interest rate loan for 15 or 30 years. Another example, would be an adjustable rate mortgage or ARM. These loans will have a fixed interest rate for 3-5 years. After that, the interest rate can be changed by the mortgage company yearly. Mortgages are usually the largest debt most people will have, and they can take many years to pay off.
So now what?
You probably have a good idea of your financial health after calculating your debt-to-income ratio. The next step is to improve your financial health by addressing your debt.
Let’s look for ways to lower your debt.
- Check to see if you can refinance your loans to a lower interest rate. Sometimes you can negotiate with creditors to lower your interest rates or payment terms. Another option may be to consolidating your debts into a single loan with a lower interest rate. Doing this will free up monthly cash to put towards paying down your debt more efficiently.
- Create a Plan to Pay Off Your Debts. It’s a good idea to create a monthly budget and realistic monthly goals to pay down your debt.
- Prioritize your debts. Typically, you want to start with unsecured debt like credit cards or personal loans. Some people may chose the credit card with the highest interest rate and some may chose the card with the lowest balance for a fast “win”. It always feels great to hit a goal!
Now you know your debt-to-income ratio and have a plan to lower your debt. There are a couple more items to keep in mind. The first thing to think about is how you use credit cards. Do you pay them off monthly or do you keep a balance and watch it grow? If you don’t pay them off monthly, I’d suggest taking them out of your wallet and switching to a debit card instead. Also, make sure you are funding your emergency savings account. This should be part of your monthly budget. After all, you wouldn’t want an unexpected expense to increase your credit card debt.
Let’s sum it all up. First, find your debt-to-income ratio. Next, take a look at your debt and prioritize the order you would like to pay it off. Next up, create a realistic budget with monthly financial goals. It’s important to celebrate yourself when you hit a goal - you’ve earned it! Also know that there is a lot of help available. You can find apps, online resources or financial coaches that can help you create a budget and track your spending. It’s important to reach out and get the help you need. You’ve got this.