Debt is becoming an increasing issue for our government, as well as for individual families. While we can’t always control how our politicians handle debt, we can control how we approach our own. Whether we are considering taking on some debt or paying some off, we should be aware of pitfalls and best practices.
The Do’s:
- Create a plan for paying back debt. You can use the avalanche method by paying the highest interest rate off first, down to the lowest interest rate loan. Every time you pay off a debt, you apply that payment amount toward the next debt. Mathematically, this makes the most sense, although it may not always work best. The snowball method is more behavioral. You pay the smallest debt first, and once it’s paid off, you add that to the next, and so forth. Sometimes this feels better because you see the little wins quicker, leading to more motivation to finish.
- Borrow good debt if it makes sense. Good debt is the kind that is used to acquire or grow assets. These assets typically appreciate in value over time. Examples include real estate, businesses, stocks, and sometimes education.
- Pay off credit card debts as soon as possible. Credit cards can quickly get up to 20% or even near 30% in interest rates. Carrying a large balance on these cards can be detrimental to your financial success.
The Do Not’s:
- Do not borrow outside your limits. As a reminder, we should not be borrowing more than 28% of our gross monthly income for a home, and no more than 36% for all other debts. This includes cars, personal loans, student loans, etc. We need to make sure the payments are manageable and that we have enough left over to save, invest, and pay for necessities.
- Do not borrow bad debt. Bad debt is debt taken out on things that depreciate in value or worth. Common in this category are cars and consumer goods like electronics, furniture, and clothing. Beware of BNPL (Buy Now Pay Later) programs.
- Do not pull from your retirement accounts to pay off your debts. Unless it is high-interest debt that is eating into your net worth significantly, the growth potential in your retirement accounts far exceeds the debt. It is wise to let these accounts grow as long as possible without interruption. This goes for 401(k) loans as well.
Check out the latest episode of the Power Up Wealth podcast for a deep dive into good debt and bad debt here.
