Attaining Financial Freedom Part 2 – Debt Management

Debt is any amount you owe an individual, bank or any entity. It could be in the form of credit card debt, student loan, personal load, mortgage, or other types. Debts usually have a predetermined interest rate and optionally, a payment period. While some debts like mortgages may have low interest rates, others like credit cards or payday loans could have hefty interest rates. Other fees like early pay off penalty and missed payment penalties could also apply. Failure to pay back loans could also have serious consequences like repossession, foreclosure and lawsuit. In certain cases, the money already paid may be forfeited.

However, not all debts are considered bad. A debt like mortgage is usually considered to be a good debt while credit card debt is considered bad. The difference between good and bad debt is not always clear cut. What is regarded as a bad debt for someone may be a good debt for another person. Consider two people who buy cars on loan. One buys the car for rideshare and makes more money from the car than the loan repayment. This will not be a bad debt for the person. The other person buys the car for pleasure and the car does not generate any income. This is a bad debt. In general, to determine if a debt is bad or good, the costs and the benefits of the loan must be considered. When the costs of a loan outweigh the benefits, it is considered a bad debt. However, when the benefits outweigh the costs, it is a good debt.

There are basically two common approaches to debt management. While some people may claim one approach is better than the other, it really depends on your situation.

• Pay off the debt with the lowest balance first, while making minimum payments on other debts. When the debt with the lowest balance is paid off, focus on the debt with the next lowest balance. Do this until you are debt-free. The major drawback of this approach is that the smallest debt may not necessarily have the highest interest rate. However, paying off some debt may be a big relief and it may encourage you to keep paying down other debts.

• Pay off the debt with the highest interest rate, while making minimum payments on other debts. When the debt with the highest interest rate is paid off, focus on the debt with the next highest interest rate. Do this until you are debt-free. While this may save you more money than the previous method, some  people may get discouraged if they don’t see any significant progress in the number of debts eliminated.

A common way of eliminating debt is consolidation. However, this has its pros and cons. All debts may be consolidated into one with lower interest rates. It is also easier to manage one big debt than multiple smaller ones. However, consolidation by balance transfer comes with associated fees which could end up making the consolidation cost more.

When it comes to debt management, some commonly asked questions are “should I save or pay off debt?” and “should I invest or pay off debt?” There is no right or wrong answer to these questions. The general rule is to have an emergency fund first, no matter how small. When it comes to deciding between investment and paying off debt, the interest rate should be taken into consideration. If the investment returns to a higher rate than the interest rate, it may make sense to invest. Taxes to be paid on the investment should also be factored it. It should be noted, however, that investments are usually unpredictable. So, a better approach could be to allocate some money to both investment and paying off debt. What percentage goes to both depends on the individual.

The best method of debt management is to avoid debt outrightly. The following steps will help you minimize, if not prevent, debt.

• Create a budget to track and/or manage your expenses based on your income. Never spend more than you earn.

• Before you buy that next item, ask yourself the following questions:

  • Is it necessary?

  • Can you afford it?

• If possible, always pay off your credit card balance every month. You might want to use autopay.

• Eliminate unnecessary bills.

• Negotiate lower rates.

• Consider making more money by switching to a higher paying job, taking a part-time job and freelancing.

The bottom line is that if you are in debt, consider the pros and cons of the debt management solutions available to you before you decide. If you are not in debt, do everything possible to stay out of it. It is easier to avoid debt outrightly than trying to get out