Best Ways To Manage Existing Debts or Seek New Debts
Poor debt management skill lowers your ability to be financially free and accumulate wealth.
- By: Coins to Asset
- October 13, 2023
In This Article
Questions to Ask Yourself?
What are the common causes of debt?
There are 4 major causes of debt or being over indebted. The first one is when your income and cost of living is relatively low. The second reason for life emergencies or unexpected events. The third reason which we will be focused on this article is poor debt management skills that leads to over borrowing and mismanagement of finances. The final reason that can cause debt problems is the type of credit that you take out.
In 1995 Debt to Income ratio in Ireland was 48. In 2021, the ratio of household debt to disposable income is 95. This means that for every €10000 income earned, €9500 of debt is outstanding.
If you are in debt, do not feel alone because there is help out there. Go to Money Advice and Budgeting mabs.ie site to seek advice on debt and money or you can go to the Citizens Advice Bureau’s for detailed advice.
Understand Your Debt
What is debt?
Some call it personal debt, consumer debt or unsecured debt. This type of debt does not include mortgage debts. Examples of unsecured/personal debt are overdraft, personal loans, car loans, credit cards etc.
Learn the cost of borrowing
Before taking out any type of debt, you need to understand the true cost of the debt. If you’re shopping for a loan, line of credit, or credit card, it’s important to consider all the costs involved — not just the monthly payment. Make sure you know your total cost of borrowing money by looking at these four things:
Loan Amount
The amount of money you borrow may influence the interest rate, terms available and possible fees you pay over the life of the loan. So, determine how much money you actually need to borrow. A higher loan amount may require a longer term to keep your monthly payments manageable. Tip Borrow only what you need. Even if you qualify for a higher loan amount, be careful of over-extending yourself. The less money you borrow, the less you’ll have to pay back.
Interest Rate/APR
When comparing rates, you will want to focus on the APR rather than simply looking at the interest rate. The APR is the amount of annual interest plus fees you’ll pay averaged over the full term of the loan. Focusing on the APR allows you to better compare the cost of borrowing from different lenders, who may all have different fee structures. Look for an account with a low APR – the lower the APR, the lower your monthly payment will be. Tip The APR you qualify for is based on your credit history. The stronger your credit score, the better APR you may be able to get from the lender. Fixed or a variable rate? Loans typically have a fixed rate and fixed term, while a line of credit or credit card usually has a variable rate and a revolving term. Know the pluses and minuses of each: With a fixed-rate loan, your interest rate and monthly payment never change. And because the payment includes both principal and interest, your loan will be paid off at the end of the term. Having a predictable monthly payment may make it easier to stay on budget and manage your finances. With a variable rate loan or line of credit, your interest rate and monthly payment can change over time. The initial interest rate may start lower than a fixed-rate loan, but can increase over time. So, keep in mind how long it will take you to pay off your debt as changes in the rate could impact your monthly payment.
Loan Term
Your loan term (or repayment period) is the time it will take to repay your loan if you only make the required minimum monthly payments.
The length of your loan term affects both your monthly payment and the total amount of interest you will pay over the life of the loan.
Consider these three examples. Each loan has the same $15,000 principal loan amount and an Annual Percentage Rate (APR) of 7.75%. But see how the loan term affects the monthly payment and the total cost of borrowing. This chart is for illustration purposes only.
With a 10-year term, you would pay $180.02 a month for a total of $21,602.40 at the end of the loan term. Compare that to a 5-year term, with a $302.35 monthly payment and a total cost of $18,141.00. Lastly, consider the 3-year term, with a $468.32 monthly payment and a total cost of $16,859.52.
Notice that the total interest paid would be $6,602.40 with the 10-year term, $3,141.00 with the 5-year term, and only $1,859.52 with the 3-year term.
As you can see, a longer loan term can help keep your monthly payment low, but that low payment comes with a higher total cost of borrowing.
Keep in mind that no matter what your loan term is, most loans allow you to pay more than your required monthly payment. The more money you are able to put toward the principal, the faster you’ll pay off your loan — and the less you will pay in interest.
Tip
Check for additional fees and charges that can increase the amount you pay — the more fees, the higher the cost of borrowing. Common fees include:
Origination fees – the amount charged for processing the loan application and underwriting services
Prepayment penalty – the fee charged if you pay off your loan before the end of the term
Annual fees – the amount you’ll pay each year for having the account
Transfer fees – the fee for transferring your balance from one credit account to another
Tip
Before you transfer a balance from one credit account to another with a lower interest rate, make sure you know what the balance transfer fee is — and if the APR will increase when the introductory period ends.
Understanding Your Borrowing Power
Your borrowing power (sometimes referred to as ‘borrowing capacity’ or ‘borrowing potential’) is how much you could borrow based on your financial situation. Your borrowing power is based on a range of factors such as your income and expenses, your dependents, and any assets or outstanding debts you might have.
Knowing your borrowing power before shopping for lenders is helpful when you’re in the market for a loan. The amount of money you can borrow depends on several factors.
Whether you’re buying a car, financing or refinancing a home, or applying for a personal loan, a lender will want to know whether you’re in a financial situation to cover your everyday living expenses plus the loan payment.
You can get a general idea of your borrowing power by totaling up all your sources of income and debts and then subtracting your debts from your income. This gives you a sense of how much money is left in your budget to cover loan payments.
However, there are other variables involved in calculating your borrowing power. These variables can change depending on the type of loan you’re looking for.
How to Increase your borrowing power?
1. Save for a bigger down payment
2. Show lenders you can save
3. Review your credit report
4. Stay current on bills
5. Pay off debt
9. Don’t leave out income: When filling out your loan application, make sure you include all your monthly income sources, including: Monthly salary Alimony Child support Side-gig income, Rental income, Investment property income Including all your income can lower your DTI ratio, increasing your borrowing power.
When to Seek New Debts
Debt to Income ratio
DTI Calculator
How to Leverage Debt To Build Wealth?
Did You Know That You Can Leverage Debt To Build Wealth
Wealth creation and debt don’t seem like they go together. On the one hand, you want to earn more money and gain more assets. On the other side is the debt that’s tying up your money. Wealthy people have learned how to use debt to their advantage. While the goal is never to be in debt forever, strategically using it to build wealth does benefit them in the long run. Most hotels and rental properties are purchased using bank loans and investors. Some business start-ups use small business loans. It’s entirely possible to use debt to build wealth.
You do need to be careful in the process not to go overboard. Focusing on one thing at a time can help you keep yourself out of hot financial waters. If you try to do too much too soon, you might end up needing to file for bankruptcy which won’t help you out in the long run. Here are some ways you can leverage debt to build wealth.
Consolidate Your Risky Debts
Many consumers have multiple credit cards that have very high-interest rates. These debts are considered risky to a bank because they have no collateral backing them. Their only recourse is to get debt collectors after you or to report missed payments if you’ve gotten behind. Spending all your money on interest will not help you build wealth. By consolidating these risky debts into one loan, you will find yourself freeing up the money you already have. Debt consolidation loans often have lower interest rates than the cards which means that getting a new loan can help you with your wealth-building strategies.
Leverage Your Home
Your home is a great source of money to help you build wealth. Wealth isn’t simply about having money in the bank. It’s also about your assets and their value as well. Your home is an asset. And when there is a lot of equity in it, you can use this equity to help you build more wealth. Some people leverage the equity in their homes to buy additional properties that they can turn into rentals. When you use your home for this purpose, you’ll want to create the right business entity and file to change address online, so renters don’t come knocking at your private home.
They use home equity loans for down payments and to get everything they need in the new home to get started. Another option is to leverage a HELOC and an additional credit card to pay off your mortgage sooner. You can invest the money you save into other wealth-building opportunities.
Use Debt for Investing
Sometimes the return on investment (ROI) is much higher than the interest you pay on a credit card. Some people use credit to start investing because it helps them to build wealth much more quickly. They turn that debt into something more, cash out some of the earnings, use those to pay off the debt, and keep cycling that way. Eventually, the debt is paid off and you end up with more in your investments than you started with.
Don’t Fear Student Loans
Student loans are another debt that can help you with wealth creation. Some jobs require a degree or advanced degree for success. This means that you can use your student loans to improve your career choices, ultimately making you more money. This gives you opportunities to build wealth. People in the financial industry often have bachelor’s degrees or higher in addition to industry-specific licenses. This helps them manage portfolios, start businesses in accounting, and so much more. Student loans are simply a tool to help you reach your career and financial goals.
Use Debt To Build a Business
While the idea of using debt to build wealth sounds foreign, it’s actually been going on for a long time. Businesses use debt all the time to get started. Building some businesses is nearly impossible without some sort of small business loan or investors. You need to get permits, buildings, hire staff, and so much more. When you’re first getting started, you probably won’t have a lot of money of your own to do all this. So small business loans are the perfect solution. Use debt to build a business and you’ll be able to create a wealth-building machine. As your business grows, there will be more opportunities to earn more and invest more.
Debt and Budget Software Tools
Software – supports UK and US – can be used offline
Budgeting: Companies like TrueBill, Copilot, and You Need a Budget help users to understand their cash flow and build a budget, even offering personalized advice.
Automated savings and investing: Stash, Qapital, and Digit offer automated savings, helping users save for a rainy day and build their nest egg. Atom Finance, Betterment, and Wealthfront help users make better investment decisions.
Paying off debt: Tally, ChangEd, and Qoins help users pay down their debt, often by rounding up transactions to the nearest dollar and putting the spare change toward student loans or credit cards.
Pay Off Debt Vs Invest?
If you are paying an interest rate on debt that is higher than what you could earn by investing money, it’s probably a smart move to pay off that debt. For example, if you are paying 16% interest on credit card debt, it’s unlikely that you would be able to earn enough to counteract that from an investment.
In general your investment portfolio could generate enough income to offset that expense in the current environment, though this is not always the case. Investments can also be volatile while paying down debt is essentially risk-free.
If the interest on your debt is not too high, figuring out how to both pay down debt and allocate money toward investing may be a good option for many people, if they can find a balance between the two.
Advantages of investing
In some cases, it’s a better idea to put money toward investments instead of completely paying off debt balances. Here’s why:
Earning higher returns
In general, returns on investments can be higher than interest on debt. Though, as mentioned above, this is not always the case and there is a risk of losing money when investing. Additionally, investments can be volatile. Though markets have historically trended upward over the long term, your investments might see ups and downs on a day-to-day basis. When investing money, it’s important to think about your risk tolerance and your long- and short-term goals.
For example, if you are saving for retirement and you are in the early stages of your career, it may be more beneficial to put money into higher-risk, higher-reward investments. At that point in your life, you have more time over the long term to make up potential losses. However, if you’re retiring in the near future, it’s often a better idea to put money into lower-risk, lower-reward investments.
Receiving tax benefits
There are several tax-advantaged ways to invest, especially for retirement. These
options include 401(k)s, Roth or traditional IRAs and other investment plans geared toward retirement savings. Generally paying back most kinds of debt, like credit card debt, does not have tax advantages. However, in some cases, student loan payments or mortgage payments can be tax-deductible, so it may make sense to pay toward these debts if the tax advantages are worth it.
Invest and pay off debt at the same time
For many people, it makes sense to work on paying off debt and investing simultaneously. Finding a balance between achieving these two financial goals looks different for everyone. Focusing too much on investing and neglecting to pay off debts can get you into a situation where you are paying more interest than you need to. At the same time, if you only focus on paying off debt, it can be difficult to meet your financial goals for retirement.
Take some time to evaluate where your debt is coming from and how much interest you are paying on it. Also look at your options with regards to the return they are delivering and their risk. Then, make an informed plan for how you want to invest and/or pay down debt. A financial advisor may be able to help you weigh your options and create a plan. A tax professional can explain the various tax consequences. Everyone’s situation is different so you should speak to a tax professional about what’s the right approach for you.
Strategies for Managing Debts
Target one debt at a time
Do you carry a balance on more than one credit card? If so, make sure you always pay at least the minimum on each card. Then focus on paying down the total balance on one card at a time. You can choose which card you target in one of two ways:
Focus on high-interest debt
Check the interest rate section of your statements to see which credit card charges the highest interest rate, and concentrate on paying off that debt first.
OR
Try the snowball method
With the snowball method, you pay off the card with the smallest balance first. Once you’ve repaid the balance in full, you take the money you were paying for that debt and use it to help pay down the next smallest balance.
2
Pay more than the minimum
Look at your credit card statement. If you pay the minimum balance on your credit card, it takes you much longer to pay off your bill. If you pay more than the minimum, you’ll pay less in interest overall. Your card company is required to chart this out on your statement, so you can see how it applies to your bill.
Quick tip
Pay a bit extra each month if you can. Every dollar over the minimum payment goes toward your balance—and the smaller your balance, the less you have to pay in interest.
3
Consolidate debt
Consolidating your debt lets you combine several higher-interest balances into one with a lower rate, so you can pay down your debt faster without increasing payment amounts. Here are two common ways to consolidate debt:
Transfer balances
Take advantage of a low balance transfer rate to move debt off high-interest cards. Be aware that balance transfer fees are often 3 to 5 percent, but the savings from the lower interest rate may often be greater than the transfer fee. Always factor that in when considering this option.
Tap into your home equity
If you have equity in your home, you may be able to use it to pay down card debt. A home equity line of credit may offer a lower rate than what your cards charge. Be aware that closing costs often apply.
If you do consolidate, keep in mind that it’s important to control your spending to avoid racking up new debt on top of the debt you’ve just consolidated.
Ready to start paying down debt? Bank of America has credit cards that offer low introductory APRs on qualifying balance transfers.
4
Review your spending
Start by categorizing your monthly spending, for example: groceries, transportation, housing and entertainment. Your credit card statement can be a helpful tool; many issuers categorize your spending. Look for areas where you can cut back. Then take the money you’ve freed up and apply it to paying down your debt.
Pay with cash
One way to manage your overall debt is to consider purchasing things with cash. Using cash or a debit card can help you avoid overspending or making impulse purchases—plus you eliminate any extra fees that may apply when paying with plastic. You’ll also have a clear understanding of how much is going out vs. coming in every week or month.
Use financial windfalls
Commit raises, bonuses or other financial windfalls to debt reduction rather than adding these funds to your monthly spending pool. Using this “extra” money to chip away at your debt can help you reach repayment goals faster.
Benefits of Paying Off Debts
Advantages of paying off debt
There are a number of reasons why it can make sense to pay down debt instead of investing. Here are a few:
Knocking out high interest-rate debt
If you are paying an interest rate on debt that is higher than what you could earn by investing money, it might be a smart move to pay off the debt. For example, if you are paying 16%1 interest on credit card debt, it’s unlikely that you would be able to put extra money toward an investment and earn that 16% or more back to counteract the interest being charged on your credit card debt. So, in this instance, it would probably be best to knock out the credit card debt before investing.
In contrast, if you have a mortgage with a 4% interest rate, you might be able to find an investment like a stock market index fund that has historically provided a 10% annual return.2 In that case, investing might be a better move than paying extra money toward the balance on your mortgage. However, it’s important to remember that investing comes with the risk of having one or multiple negative years, which should be factored into your decision.
Improving your credit score
Another benefit of paying down debt is that it will improve your credit score. A better credit score can help you in a number of ways. For example, you may have an easier time applying for other loans, you might be eligible for lower insurance premiums and you’ll likely have an advantage if you apply for an apartment.
Alleviating the stress of being in debt
It’s important to think about your mental health, not just your financial health, when making a decision about investing or paying down debt. If being in debt is keeping you up at night, it might be a good idea to pay off your balance first, and then focus on investing without feeling stressed about your debt. Additionally, paying off debt is usually risk-free, whereas investments always carry some degree of risk.
The basics of investing
Investing is putting money toward something like a stock, bond, real estate, or something else with the intention to increase the value of the money you invested over time.
While not everyone actively invests their money in stocks, many people invest their money passively by contributing to retirement accounts through work, like a 401(k).
Final Thoughts
Rarely will savings and investment rates outperform loans, Building wealth is counterproductive when there is huge debt
For many people, it makes sense to work on paying off debt and investing simultaneously. Finding a balance between achieving these two financial goals looks different for everyone. Focusing too much on investing and neglecting to pay off debts can get you into a situation where you are paying more interest than you need to. At the same time, if you only focus on paying off debt, it can be difficult to meet your financial goals for retirement.
Take some time to evaluate where your debt is coming from and how much interest you are paying on it. Also look at your options with regards to the return they are delivering and their risk. Then, make an informed plan for how you want to invest and/or pay down debt. A financial advisor may be able to help you weigh your options and create a plan. A tax professional can explain the various tax consequences. Everyone’s situation is different so you should speak to a tax professional about what’s the right approach for you.
