Day 1 Reassess: Get a Handle on Your Debt
WHAT YOU NEED TO KNOW
The first step to becoming debt-free is understanding how debt works.
Debt is money borrowed from an institution or person with the promise of paying it back at some point, often with interest.
Any debts or loans you owe—whether for credit cards, student loans or something else—are called financial liabilities. If you explored your Money Center dashboard after linking your accounts, you saw these accounts in red, while your assets—savings, investments or businesses, real estate or valuable possessions you own—were colored green.
Debt is never 100% a good thing, but some kinds of debt are worse to have than others.
Good vs. Bad Debt
Ultimately, what differentiates good debt from bad debt is the interest rate. Good debt tends to have a low interest rate, and bad debt tends to have a higher rate.
Good debt may also be tax-deductible (check with your CPA or tax preparer to be sure). Real estate sometimes has the added bonus of increasing in value. However, good debt can easily become bad debt if it is taken on without a solid plan for repaying the loan. As we saw in the housing market crash of the late 2000s, a mortgage is very bad debt when the person holding it can’t afford her payments because of ballooning interest rates.
WHY IT MATTERS
Debt is important to understand, because most of us deal with it at one point or another.
According to a nationwide survey conducted by LearnVest and Chase Blueprint, 31% of respondents say that credit card debt is keeping them from reaching their financial goals, making it the leading reason. More than half of respondents do not pay their monthly balances in full, and the average credit card debt is $5,000.
Student loan debt is also a significant factor, with about one in four correspondents having such debt and the average balance equalling more than $30,000. However, as we explained above about "good debt," most feel that the money they spent on their educations was worth it.
YOUR TO-DO: Calculate How Much Your Debt Is costing You
There are two kinds of interest: simple and compound. When you have debt, simple interest is generally the better kind of interest to have.
Simple interest is a percentage multiplied by the amount you borrow and the length of time you promise to pay it back. For example, if you borrow $100 at an interest rate of 1%, and you have to pay it back in one year, the simple interest is $1. So you’ll pay back $101.
The more complicated kind of interest, compound interest, is the worse kind of interest to have on your debt. (On the other hand, if you have that kind of interest on an investment, then yay for you! With compound interest, it will be easier for you to make money on it.)
When interest is compounded, it is calculated over and over again at set intervals, so it builds upon itself to make interest grow continually (as shown above). Let's say you take out a $10,000 student loan that compounds annually at 5%, and you promise to repay it within three years. If you don’t make any payments, you will owe $10,500 after the first year, and then the second year, you'll pay 5% on the amount you borrowed, plus on the interest that accrued the year before: $11,025. The same will happen the third year, so by then, you'll owe $11,576.25. Over the term of the loan, you’ll be paying almost $1,600 in interest!
One of the reasons credit card debt is considered bad debt is because credit card interest compounds.
1. Estimate the cost of your simple interest.
OK--so you get that compounding interest can quickly snowball. Still, interest on other kinds of debt can also add up. There are actually some types of simple debts whose interest can be reduced if you pay the debt more quickly. At the moment, however, just make an estimate of how much this debt is costing you. For loans such as student loans and car loans, you should be able to find either the percentage you are paying in interest, or the dollar amount you are paying in interest right on your statement.
- To calculate how much you will pay on your student loan, use this Bankrate calculator.
- To calculate how much you'll pay on an auto loan, try out Bankrate's auto loan calculator.
2. Estimate the cost of your compound interest.
For your credit card debt, find out the following using this calculator:
- How much you will pay in interest if you only pay the minimum, or whatever amount you are currently paying monthly.
- How much you will pay in interest if you increase your monthly payment.
3. Tally up how much your debt is costing you.
Once you have your sum, think of what you'd rather do with that money. Finance a dream vacation? Have that much more in savings? Have that much more in your retirement account? Come up with a motivating list, and over the next few days, we'll help you get on track to pay down your debt and eventually put your money toward your dreams.
Your Next Steps
1. Take a deeper dive into understanding how debt works.
- Sometimes debt can actually be good. Learn how in Debt 101.
- And, surprisingly, even compound interest can work in your favor. Find out how in Your Financial Frenemy: Compound Interest.
- As you continue on your journey to become debt-free, keep in mind these Top Debt Mistakes to Avoid.
- Feeling the weight of student loan debt? Here's what you need to know to pay it off.
2. Negotiate down your APR.
- Shocked by how much your interest was costing you? This checklist was made for you: I Want to Negotiate Down My Credit Card APR.
3. Get inspired!
Many other people have endured debt to pay it off. So can you! Learn from their examples.
- She was making $30,000 a year. But she still paid of $35,000 in debt—with the help of "the money lunch."
- Her boyfriend asked her how much she owed in debt. She didn't know, so she tallied it up: $90,000. And three years later, it was gone.
- Tracking every dollar: One of our editors paid off her student loans by logging every dollar she spent.
- Her husband found out she owed $25,000 in credit card debt. With auto-payments to credit cards and a lot of baking, she paid it off in two years.
- This mom of six kids had a mortgage, auto loan and credit card debt—all of which totaled $89,000. She paid it off within six months by getting really creative.
4. Get motivated!
- Finally, create a financial vision board. When you're feeling your motivation flagging, just take a quick look at this vision of your future life to remember what you're working toward.
- And, while you're at it, also take a moment to appreciate what you have now by making a gratitude list.