How to Manage and Pay Off Debt

Debt is a part of modern life and, if properly managed, can be a useful tool for improving your financial health. But debt can be confusing, and many people have questions about debt.

The reality is, many Americans struggle with paying off their debt, either due to high interest rates, oversized monthly payments or a lack of financial planning. If ignored, debt can often snowball out of control and slow your progress toward financial goals.

For this reason, it’s important to plan for ways to manage and pay off your debt quickly. But where should you start? Which types of debt should you pay off first?

Finding the balance between paying off debt and meeting your other financial goals can be a challenge. But, with a focused approach and a few simple changes to your habits, you can develop a plan for managing your debt in the short and long term.

What is debt?

The term “debt” refers to any money that one entity—typically a person, business or government—owes to another entity. Debt is often generated in the form of loans, where a financial institution lends out money with the expectation that it will be paid back over a set period, usually with interest.

Basic kinds of debt: installment debt vs. revolving credit

You can organize debt into two general categories: installment debt and revolving credit.

• Installment Debt – The money you borrow to purchase large-ticket items, such as a home or a vehicle. For this type of debt, you take out a loan for a set amount and agree to pay it back over time with a certain interest rate. Often, interest rates for this type of loan are low and the terms lean more in the favor of the borrower due to the low-risk nature of the debt. For this reason, installment debt is often best for long-term situations such as paying off a house.
• Revolving Credit – A form of open-ended credit where you can borrow up to a certain amount as long as you continue to make monthly payments. Common examples of revolving debt include credit cards and lines of credit. Revolving credit is generally preferred for short-term situations (of less than a year), and generally has higher interest rates due to the greater risks involved for the lender.

Is all debt bad?

No. In fact, taking on certain kinds of debt can actually help your financial situation, provided you take the time to properly manage it.

The question of whether debt is bad really comes down to three factors:

1. Does the debt improve your life or financial situation? For example, student loans and mortgages are generally seen as good debt because they improve your ability to earn more money and build wealth.
2. Does the debt have a relatively low interest rate? Debt with an interest rate of greater than 10% can become a burden if you can’t pay it off quickly. Your ability to pay off high-interest debt in full before it accrues interest plays a large part in whether the debt is good or bad.
3. Does the debt negatively impact your debt-to-income ratio? Your debt-to-income ratio is, in its most basic form, a comparison of how much you owe in debt each month versus how much you earn each month. Many financial institutions avoid lending money to people who use a sizeable portion of their monthly income to pay down other debts. This means you generally shouldn’t pay more than 36% of your monthly take-home pay on minimum debt payments.

Examples of good debt

One example of good debt worth noting is a home equity line of credit, or “HELOC.” This form of credit lets you borrow against the equity you have in your home.

For example, if your house is valued at $400,000 and you have an outstanding mortgage of $150,000, that means you have $250,000 worth of equity in your home. With a home equity line of credit, you could borrow against this equity (generally up to 85% of the total amount) to fund home improvement projects, refinance other loans or otherwise generally improve your financial situation.

Debt from a HELOC could:

1. Help improve your financial situation by giving you the flexibility you need to meet your goals.
2. Likely have an interest rate of below 10%, meaning more of your money goes toward paying off the principal.
3. Likely have a relatively low impact on your debt-to-income ratio due to the long repayment period.

In this situation, the benefit of the flexibility provided by the HELOC line of credit will almost always outweigh the interest accrued and the effect on your debt-to-income ratio.

Know your debt strategy

Regardless of whether your debt is good or bad, it’s important to have a debt repayment plan in place to help you manage your monthly payments. While there are many different strategies for paying down your debt, it all really comes down to one key word: balance.

Everyone has a unique approach to how they manage their finances. For this reason, the best kind of debt strategy is the one that works for you.

Your strategy should be realistic and work with your lifestyle to reduce the overall burden of debt. It should allow you to move through life more freely without the stress of high monthly payments or oppressive interest rates.

Most importantly, your debt strategy should also free up your finances so you can safely save and invest toward your future goals.

3 common methods for paying off debt quickly

Over the past few years several strategies have proven effective for helping individuals pay off their debts quickly:

• Snowball method – The process of paying down small debts first and then building momentum to tackle the rest. The snowball method lowers your monthly debt-to-income ratio by focusing your resources on the smallest debts first. Then, once these debts are paid off, you can use your newly freed-up monthly income to pay down the larger debts faster.
• High-interest paydown – All debts have different interest rates. In this strategy, you focus on paying down the debts with the highest interest rates first. This will save you the greatest amount of money in the long run by lowering the total amount of money you’ll pay over the life of the loans. However, it can be hard to build and keep momentum if your debts with the highest interest rates are also the ones with the most money outstanding.
• Debt consolidation – If you find that the financial effects of your debt are too much to bear, you may want to consider debt consolidation. This means that you bundle all your debts in one place, preferably with a lower interest rate or monthly payment. While you’ll still owe the same amount, this strategy can make the day-to-day management of your finances easier by focusing all your efforts into a single, more manageable loan.

Each strategy has pros and cons. What’s important is how each strategy will affect your specific financial situation.

While the snowball method may make your monthly payments easier, you’ll generally end up paying more over the life of your loans. On the other hand, focusing on the debts with the highest interest rates first will save you money in the long run, but may not help your immediate financial situation.

Finding the right balance between your short-term goals and your long-term financial health is something you’ll have to determine either on your own or with the help of your local banker.

5 tips for paying off and managing debt

In addition to the strategies outlined above, it’s wise to consider a few basic tactics for paying off and managing your debt in the short term.

1. Set achievable debt payoff goals

The first and most important step in your debt payoff journey is to set reasonable and achievable goals that account for your financial needs now and into the future.

Paying off debt is often a marathon, not a sprint. For this reason, it’s important to create a plan that accounts for your needs. Reducing your expenses to only the bare minimum—while potentially effective—may only make it harder to stick to your plan in the long term.

Finding the right balance between maintaining a comfortable standard of living and paying off your debts quickly is often the best way to meet your debt payoff goals.

For example, a reasonable goal could be to set aside 10% of your monthly take-home pay for paying off your debt (on top of the minimum payments you’ll already be making). Or, if you like absolute numbers, you could make a goal to pay an extra $100 on the debt that has the highest monthly interest rate.

Whatever goal you decide on, it’s a good idea to build a habit of paying more than the minimum on all your debt. This can help you put more money toward the principal, meaning you’ll end up paying less in interest over the life of the loan.

2. Understand cash flow and where your money goes

Another important aspect of your debt payoff strategy should be a monthly budget that accounts for your debt payments.

Keeping a budget is always good advice, but it’s particularly important when you’re trying to pay off your debt quickly. Knowing where your money is going is important for understanding where you can cut back to put more money toward paying off your debt.

Further, accounting for your purchases ahead of time is an easy way to limit the amount of debt you take on through unexpected expenses or excessive spending.

As one quick tip, budgeting experts will often point to the 50/30/20 rule as a good baseline for building a budget to pay off debt. Under this rule you would spend roughly 50% of your monthly take-home pay on “needs” like your mortgage or food, 30% of your pay on “wants” such as dining out and 20% on meeting financial goals such as paying down debt.

Regardless of whether this specific budgeting strategy works for you, it’s important to have an idea of where your money is going so you can better adjust your finances to pay down debt over time.

3. Reduce your monthly bills with smart spending habits

Once you know where your money is going, you can take steps to reduce your monthly bills and allocate more money toward paying off your debt.

As a few common expenses can have an oversized effect on your budget, you may be able to lower your monthly food costs by meal prepping or eating out less. Or, you could make a habit of creating a shopping list before you go to the store to help minimize impulse purchases.

Finding even $50 of room per month to reduce your budget can lead to significant savings in the long run if you put that extra money toward the principal of your debt.

4. Build out an emergency fund to limit future debt

Another important tip to help you pay off your debt and avoid future debt is to build out an emergency fund that can cover roughly three to six months’ worth of expenses. An emergency fund can help you manage any unexpected short-term expenses that may otherwise harm your debt repayment efforts.

Unexpected expenses such as medical bills or car repairs can have a profound effect on your finances if you don’t have the money to pay these bills upfront. Creating an emergency fund can help you spread out these costs over several months to lessen the impact these expenses will have on your financial situation.

And most importantly as it pertains to debt, having an emergency fund on hand can prevent you from having to take out loans for these unexpected expenses. By stashing a small amount into your emergency fund every month, you can gain the flexibility you need to better manage your finances and work toward improved financial wellness.

5. Explore debt relief options

If you’re finding debt overwhelming, there are debt relief options that can help you get your debt situation under control.

If your interest rates are too high, it may be worth exploring debt consolidation or refinancing options. For more specific types of debt, such as medical debt or student loan debt, you can research loan forgiveness or other programs that can help you write off portions (or even the entirety) of the debt.

And if you’re experiencing exceptional circumstances, you can also reach out to your lender directly to work through other options that may be available to help you get back on track. A good financial partner will be there to help and guide you, even when times get tough.

Regardless of which path you choose, the important thing to remember is that there are debt relief options available. If you have any questions about ways to lower your debt burden, you should schedule an appointment with your local banker to talk over your options.

The importance of having a plan

While there’s no one “best” method for managing your debt, one thing is clear—you need to have a plan. And with your plan, the trick is finding a strategy that works for your specific situation.

Taking steps to build a budget that accounts for your debt payments is a great way to start, but it’s important to find the right balance between managing your short-term financial health and meeting your long-term financial goals.

Remember, paying off debt doesn’t happen overnight. It’s worth taking the time to find the right balance that can help you make regular payments toward your principal in the months and years to come while you work toward an even brighter financial future.

Want help getting started? Schedule an appointment to meet with a dedicated expert at an Associated Bank near you. We’re here to help you meet all your financial goals, and we can help guide you toward a path that works for your unique situation.