Debts are double-edged swords in the financial world. They can make your dreams come true, help you reach your goals faster and even help you build wealth. Yet, they can quickly get out of hand if not managed properly.
Efficient debt management is an indispensable part of ensuring your financial stability. It encompasses a range of practices: creating a financial plan, choosing a debt repayment method and developing healthy spending habits. With our detailed debt management guide, you can learn the steps and practices to reduce debt and gain financial stability.
Understanding Debt Management
Debt management involves strategically lowering your debts over time and eventually paying them off. This requires efficient financial planning and execution.
The aim of debt management is not only to bring you out of debt. It’s also about doing that as quickly as possible and in a way that your debts don’t run amok or hamper your financial health.
Why Is Debt Management Important?
Debt management can help you make timely payments and minimize interest payments. It can also help you keep from compromising your savings and other financial obligations.
However, it can also help you manage your money and maintain your financial health with many long-term benefits, such as:
- Reduced Stress: Seeing your debts dwindling each month can be a constant source of satisfaction. The reduction in debt can mean lower stress levels.
- Improved Credit Score: On-time payments improve your credit score, which makes it easier to get loans. It also means more eligibility for lower interest rates and other credit-related benefits in the future.
- Greater Financial Freedom: Making timely payments with a dedicated strategy keeps you in control of your debts. It can put you on the path to a debt-free life and greater financial freedom.
The question is not whether or why you should get into debt management, but how.
Getting out of debt starts with creating a robust financial plan that balances your debt repayments with the rest of your finances.
Creating A Financial Plan That Covers Your Savings And Expenses
Every debt management strategy starts with a financial plan that covers your savings and expenses. At the same time, it sets you up to efficiently handle your debt.
A well-structured plan balances debt repayment with your other financial needs. These include daily expenses, savings, insurance, investments and other goals. Whether you want to manage your debts yourself or seek professional help, creating a financial plan is the first step in debt management.
Steps To Creating A Financial Plan
You can create a financial plan yourself or with the help of a licensed financial planner. Here are the steps to create a well-structured plan for your needs:
- Step 1: Income Assessment: Start by listing all your sources of income and find an overall monthly or annual figure.
- Step 2: Expense Tracking: Write down all your expenses. This should include everything from rent, debt payments and internet bills to dining out and last-minute weekend plans. Break down your expenses into categories such as “needs” and “wants” to distinguish between essential and nonessential spending.
- Step 3: Savings Goals: Set aside some amount to build an emergency fund that can accommodate your living expenses for at least three zero-income months. Dedicate some amount toward your long-term financial goals, too, such as retirement savings and investments.
- Step 4: Creating A Budget: Once you have all the figures, it’s time to do the math. If your net (post-tax) income is greater than the sum of your expenses and savings, great news! You can take care of your expenses, debts and savings and still have a surplus. However, if your income falls short of your expenses and savings goals, you might have to cut down on your expenses or savings (or both) to achieve a balance.
A budget calculator can be beneficial in this process. It can help you visualize your financial situation and make adjustments until you arrive at the right budget.
Reviewing Your Financial Plan
Your income, expenses and needs are subject to change. You can ensure your financial plan is always in line with your changing financial situation by regularly reviewing it.
Have you had a salary cut or earned a raise? Update your income. Got a new pet? Add it to your expenses. Want to retire early? Make sure it reflects in your savings goals. This way, you can stay on top of changing situations and prepare for efficient debt management.
Three effective methods of lowering debt are a debt management plan, the debt avalanche method and the debt snowball method.
Developing A Debt Management Plan
A debt management plan (DMP) is a strategy offered by a credit counseling agency to help you repay your loans faster and regain your financial stability. It can be a smart debt management option if you have multiple debts and want a convenient and cost-effective way to deal with them.
Only unsecured loans (credit cards and personal loans) are covered in a debt management plan. Secured loans—such as mortgages and auto loans—and student loans are not eligible.
A credit counseling agency may also charge a fee for setting up a debt management plan. However, you will likely save much more than the charges you’ll pay.
How Does A Debt Management Plan Work?
Setting up a debt management plan usually involves the following steps:
- Counseling: You schedule a free counseling session with a credit counseling agency.
- Assessment: The credit counselor assesses your outstanding debts, income, expenses and overall financial situation to determine the best way forward.
- Negotiations: If the counselor decides that a debt management plan is the best option, they start negotiating with your creditors on your behalf. The negotiations may include a lower interest rate, waived late fees and penalties and reduced monthly bills.
- Debt Consolidation: If the negotiations work out, the agency consolidates your loans into a single account and sets up a repayment plan for you.
You have to make just one cumulative monthly payment to the agency, which then pays all your creditors on your behalf.
How To Find A Credit Counseling Agency
Plenty of scams are running in the name of credit counseling, so it’s important to be careful when choosing your agency.
Here are five questions you must consider when choosing a credit counseling agency:
- Is the agency certified by the National Foundation for Credit Counseling (NFCC) or the Financial Counseling Agency of America (FCAA)?
- Which of your debts can be included in the DMP?
- How long will it take to pay off your debts with the DMP?
- What services are included in the agency’s debt management plan?
- Are there any hidden or upfront charges?
As a rule of thumb, look for agencies certified by NFCC or FCAA. Moreover, the fees charged by the agency should be less than what you will save via reduced interest rates and waived fees. Steer clear of agencies that charge hefty fees or promise instant debt elimination.
Utilizing The Debt Avalanche Method
A debt management plan is not the only way to pay off your debts. Many times, a DIY repayment strategy and steadfast discipline are all you need to manage your debts.
The debt avalanche method is an accelerated debt repayment strategy that helps you pay off your debts faster by first focusing on the highest-interest debts. This strategy only considers the interest rates of your debts and not the debt amounts or actual interest.
How Does The Debt Avalanche Technique Work?
Under a debt avalanche plan, you pay the minimum due amounts to all your creditors every month, then pay any extra available money to the debt with the highest interest rate. When the highest-interest debt is eventually paid off, you repeat the method with the remaining debts.
For example, suppose you have three outstanding debts with different annual rates of interest and minimum payments:
Let’s say your budget allows you to spare $500 each month for debt repayments. Then, with the avalanche method, you pay the minimum amounts (totaling $300/month) to the three debts and allocate the remaining $200 from your monthly repayment funds to the credit card bill.
This way, the credit card bill will be paid off first, followed by the personal loan of $1,000 and finally the personal loan of $5,000.
Is The Debt Avalanche Method Right For You?
The debt avalanche method will suit you if you want to save more money in the long run by reducing your interest over time.
However, this strategy can also test your patience. For example, if your highest-interest loan has a large principal, you will have to wait a significant amount of time until the first loan is settled.
Trying The Debt Snowball Method
The debt snowball method is a repayment plan that focuses on paying off the smallest debts first. Unlike the debt avalanche method, the snowball method focuses on the principal (the original debt amount) and ignores the interest.
How Does The Debt Snowball Technique Work?
With the debt snowball method, you pay the minimum amounts to each of your debts every month and allot an extra monthly amount to the smallest debt. Once that debt is settled, you repeat the process with the remaining debts until all your debts are paid off.
Let’s take the previous example again:
With a monthly repayment fund of $500, you can pay the minimum amounts to each of the debts every month. The remaining $200 goes to the personal loan of $1,000 since it’s the smallest debt.
Once that loan is paid off, you will shift the extra money to the credit card bill, which will be paid off second, followed by the other personal loan of $5,000 that’ll be paid off last.
Is The Debt Snowball Method Right For You?
The overall savings in the debt snowball method are usually less than in the avalanche method. But the focus here is on getting rid of debts faster to build momentum and keep you motivated.
If you are someone who prefers visible progress over long-term savings, the snowball method might be a better option for you.
Handling debts yourself is one of the best things you can do to improve your financial well-being. However, you don’t have to do it alone. There are some powerful tools for debt management that can simplify the overwhelming parts, like calculation and organization.
Let’s talk about two useful debt management tools: debt repayment calculators and budget calculators.
Debt Repayment Calculators
A debt repayment calculator simplifies the process of creating a debt repayment plan and lets you compare different plans within seconds.
You can add the details of all your debts—such as the outstanding amount, interest rate, minimum monthly payment, extra repayment amount and so on—and create a repayment plan.
Depending on the tool, you can also compare different repayment plans, such as the snowball and avalanche methods.
For example, the free Debt Payoff Calculator from Credello creates two separate plans based on the avalanche and snowball methods. It compares the interest, savings and durations in the two cases to help you decide which one’s better for you.
Budget Calculators
A budget is the first step in efficient debt management. However, it involves planning, calculations and monitoring that can feel complicated. This is where a budget calculator tool can help.
A budget calculator typically comes with preset fields covering the different aspects of your expenses and savings. All you need to do is fill out the fields with relevant figures, and a summary of your budget is a click away.
For example, the Voya Budget Calculator is a free tool that breaks down your budget into “needs,” “wants” and “savings.”
Once you create your budget using a budget calculator, you can usually save it as a PDF or other file. Then you can refer to it for managing your income, expenses and debts more effectively.
Other Budgeting Tips
Using debt repayment and budget calculators can be beneficial in your financial planning. Try these budgeting tips in conjunction with your calculators:
- Identify where you can set up automatic payments to stay on top of your debt management
- Discover where you can reduce discretionary spending or cut back on bills
- Regularly review your budget at a glance and make adjustments as needed
- Allocate savings to increase financial security and avoid additional debt
Maintaining Credit Health: Understanding Hard Inquiries And Credit Utilization
Knowing how to manage debt repayments is crucial to maintaining your credit health, but it’s not the only thing you need to know. Maintaining a healthy credit score is no less than an art, and it goes beyond paying your debts on time.
Here are three practices and tips that can help you manage credit responsibly and maintain good credit health:
1. Minimizing Hard Inquiries
Hard inquiries usually happen when you apply for a new loan or credit card or request a lower interest rate while setting up a DMP with a counselor. Through these inquiries, creditors look into your credit report to decide if offering credit or related benefits to you is safe.
Every hard inquiry negatively impacts your credit score, reducing it by a few points. While this is a temporary impact, you can try to minimize hard inquiries by limiting new loan or credit card applications.
2. Limiting Credit Utilization
Credit utilization is the percentage of credit you have used from your total available credit limit across all loans and credit balances. It’s a purely mathematical value that can be calculated as:
Credit Utilization Ratio= 100 x Total Pending Dues/Total Available Credit Limit
Maintaining a low credit utilization ratio is one of the best habits for maintaining excellent credit health. In general, try to keep it below 30%. A high credit utilization ratio is bad for your credit score.
3. Using Balance Transfer Credit Cards
Balance transfer credit cards are special-purpose cards that let you shift all your outstanding credit card balances to a single card. Most of these cards come with an introductory 0% APR offer for the first six-18 months. This means you can enjoy 0% interest on the transferred balance during this period.
These cards can be a good alternative to debt management plans if your debts consist of mainly credit cards. However, the amount you can transfer is limited to the credit limit on the new card. You also have to pay a transfer charge, which is usually 3%-5% of the transferred amount.
However, with this option, it’s critical to remember to pay your debts on time. Defaulting on your payments can revoke the introductory 0% APR offer.
Working With A Debt Relief Company
While managing your debt can help, it’s not always possible for everyone to stick to a repayment schedule. This is especially true if you have to deal with a mountain of accumulated debts.
Debt relief companies are for-profit organizations that negotiate a reduction in your total debt. If the negotiations are successful, you can settle your debts by repaying less than you owe. In other words, you get debt relief.
How Debt Relief Works
The process of working with a debt relief company is similar to the process of working with credit counseling agencies.
- You schedule an initial (usually free) consultation to discuss your financial situation and determine your eligibility for debt relief.
- If you are eligible, the company starts negotiating with your creditors. You may be asked to pause your payments while the negotiations happen.
- If the negotiations are successful, you can get on a repayment plan and pay off your debts without paying the full owed amount.
Choosing A Debt Relief Company
Look for the following characteristics when choosing a debt relief company:
- Accreditation by the NFCC or FCAA
- An A or A+ rating from the Better Business Bureau (BBB)
- Additional services like debt management and consolidation
- Transparent fees
- Free initial consultations
Stay away from shady companies without accreditation. Avoid those that reach out without any prior communication and offer ultra-lucrative or guaranteed results. Always do a background check on BBB, Trustpilot or other review websites.
Some debt relief companies offer multiple options. For example, Achieve is a company that offers debt resolution and consolidation programs, as well as Achieve personal loans. Knowing what options are available can help you choose the company that’s right for you.
Disadvantages Of Working With A Debt Relief Company
While debt relief companies can help you pay off your debts without paying the full amount, they come with many catches, such as:
- Hefty settlement fees (typically 15% to 25% of the forgiven amount)
- Negative impact on your credit score
- Taxes on the forgiven debt
- Rejection of debt relief by your creditors
While debt settlement may seem a lucrative way to get out of debt faster, it’s not always as effective as you may think.
Alternatives To Debt Relief Companies
If you are overburdened with debt, even a debt relief company may be unable to help you. In such cases, you might need to turn to some other options for settling your debts, such as:
- DIY Negotiations: If you are good with negotiation and communication, you can try negotiating with your creditors. This can mean lower interest rates, better repayment plans and even debt relief.
- Home Equity Loans And HELOCs: If you own a home or are still paying an EMI (equated monthly installment) on it, you can use part of your home’s value to get a secured loan at a low interest rate. You can use this loan to pay off your unsecured loans.
- Bankruptcy: Consider it the last resort if you have a large amount of outstanding debt and cannot pay it off. Chapter 7 and Chapter 13 bankruptcies are the most common, though you should contact a financial adviser to understand your options.
In the end, it’s you and your specific financial situation that defines your next steps.
Managing Debt Leads To Financial Wellness
While you can’t make your debts magically disappear, you can play your part in managing them efficiently. You can start by developing a comprehensive financial plan that balances your debts with your other financial goals.
Understand your financial situation and go for a debt management method that best suits your needs. Whether it’s a DMP via a counselor or a DIY repayment strategy like the avalanche and snowball methods, you can find the right solution for your needs. Use tools like budget and debt repayment calculators to stay on track without getting overwhelmed.
Remember that the goal is not just to come out of debt but to set the foundation for long-term financial stability and a financially secure life!
Photo courtesy of Evgeny Atamanenko/Shutterstock