How does debt affect your credit score?
Debt affects your credit score because it determines your credit utilization ratio, which is the percentage of your available credit that you're using. If you have $20,000 in available credit across all your credit cards and combined balances of $16,000, then your credit utilization would be 80%.
A high credit utilization negatively impacts your credit score. With the most widely used type of credit score, the FICO® Score, 30% of your score is based on your credit utilization.
Although there's no specific safe zone to target, it's best if you don't use more than 20% to 30% of your available credit.
Debt repayment strategies
There are several popular debt repayment strategies: the debt snowball, the debt avalanche, debt consolidation, and a debt management plan. By understanding how these different strategies work, you can pick the one that's right for you.
Debt snowball
With the debt snowball method, you always put your extra money toward the debt with the smallest balance.
Here's an example -- you have a credit card with a $400 balance, another with a $2,000 balance, and a third with a $5,000 balance. You make the minimum payments on each card, and any money left over would go toward the card with the $400 balance. Once you pay off that card, you'd put your extra money toward the card with the $2,000 balance.
Mathematically, the debt snowball method isn't optimal. You'd save more money on interest by prioritizing debts with the highest interest rates.
But this method is extremely popular because it works from a psychological perspective. When you prioritize your smallest debt, you get one of your debts eliminated as quickly as possible. That gets a win under your belt, which is often just what people need to stay on track.
Debt avalanche
The debt avalanche method involves putting your extra money toward the debt with the highest interest rate. After you pay it off, you progress to the debt with the next highest interest rate, and so on.
The obvious benefit of this method is that it saves you more money on interest compared to the debt snowball. It can also help you pay off your total debt more quickly. The downside is that it will likely take you longer to start eliminating the debts on your list, which could make it hard to stay motivated.
Debt consolidation
Debt consolidation is combining multiple debts into one. The most common ways to do this are by getting a personal loan or a balance transfer credit card, and then using that to pay off all your debts.
Since you'll have only one monthly payment to make after debt consolidation, this makes debt repayment much simpler and reduces the odds of a missed due date. In many cases, debt consolidation can also result in a lower interest rate.
Debt consolidation isn't available to everyone, because you usually need good credit to qualify for either a balance transfer credit card or a debt consolidation loan with a reasonable interest rate.
Debt management plan
If you decide to work with a credit counseling agency, one option it may present is a debt management plan. The agency would then negotiate your debts with each of your creditors and arrange a payment plan that you can afford. Once the plan is set up, you make one payment to the credit counseling agency per month, and it distributes your payment to each of your creditors.
A debt management plan simplifies your debt repayment, because you'll have only one payment to make. Although credit counseling agencies typically won't negotiate the amount of your debt with your creditors, they can negotiate other items, such as your monthly payment amount or fee waivers for any fees you've been charged.
Debt repayment options
There are several options that could help with getting rid of your debt. Balance transfers and personal loans are both popular and effective if used properly. But if your debt is too much to handle, debt settlement and bankruptcy can work as last resorts. Here's a closer look at each debt repayment option:
Balance transfer
A balance transfer involves moving a balance from one credit card to another. This allows you to consolidate your debt and potentially get a lower interest rate.
If you have credit card debt and a good credit score, it makes sense to look at balance transfer cards. The best cards offer 0% intro APRs, and that can save you quite a bit of money on interest.
Personal loan
You can apply for a personal loan, and then use it to pay off existing debt. This is another way to consolidate your debt so that you have only one monthly payment. Depending on your credit, you may also be able to get a loan with a lower interest rate than your debt.
Debt settlement
Debt settlement is when either you or a third party negotiates with a creditor to pay off your debt for less than you owe. For example, if you owe $5,000, you could try to settle the debt for $4,000.
You'll need to be ready to pay the full settlement amount if the creditor agrees to it. After the settlement is complete, the creditor will likely report the debt as settled, which can cause your credit score to drop significantly.
Bankruptcy
There are two common types of bankruptcy that consumers can file to discharge debt: Chapter 7 and Chapter 13.
In Chapter 7 bankruptcy, you liquidate your assets and, in return, you're able to discharge most types of debt. In Chapter 13 bankruptcy, you set up a payment plan, follow this plan to repay as much of your debt as possible, and then you can discharge remaining debts after completing that plan. Payment plans generally last from three to five years.
The type of bankruptcy you qualify for depends on your financial situation. If you make enough money to pass what's known as the means test, then you'll likely need to file Chapter 13 bankruptcy and follow a payment plan.
Although filing bankruptcy can be beneficial because it allows you to discharge debt, it will also impact your credit score for several years.
What is your debt-to-income ratio?
Your debt-to-income (DTI) ratio is your combined monthly debt payments divided by your monthly income.
The reason your DTI ratio is important is because creditors look at it when deciding whether to approve applications for new credit. If your DTI ratio is too high, you could have trouble getting approved for credit cards, mortgages, or other types of loans.
How can you stay out of debt?
To stay out of debt, you need to adopt the right financial habits. That includes avoiding excessive monthly expenses, budgeting and tracking what you spend, prioritizing your savings, and building an emergency fund.
Avoid excessive monthly expenses
Ideally, your essential monthly expenses should be no more than 50% of your income. Although this may not be realistic for everyone, you should try to avoid taking on too much. The consumers who get the fanciest homes and cars they can afford tend to be the ones who end up in debt.
By being conservative with your fixed expenses, you'll have a comfortable buffer in case of a financial emergency. If you spend too much, even a relatively small expense can require you to borrow money.
Budget and track what you spend
There are many different budgeting systems out there, but what's important is finding one that you like. No matter how you set up your budget, it should have clear limits on how much you'll spend each month.
To ensure you follow these limits, you should also track your spending. A budgeting app, such as Mint or You Need a Budget, can help with that.
Prioritize your savings
The best financial habit you can start is saving money first, before you do anything else with your paycheck. Simply choose an amount and set up an automatic transfer to your savings account after each pay period.
Build an emergency fund
Your first goal with your savings should be building an emergency fund. When you have any sort of unexpected expense, an emergency fund can cover it so that you don't need to borrow money and go into debt.
Which debt strategy is right for you?
We've gone over quite a few ways to pay off debt. Now we'll cover how you can choose the best option for your situation. This depends on the answers to two questions:
- Can you make at least minimum payments on all your debts?
- Do you have good credit (a credit score of at least 670)?
Here's what debt strategy to choose based on your answers:
You can make all your payments and you have good credit
Apply for either a balance transfer credit card or a personal loan to consolidate your debt. A balance transfer card is a better choice if you have only credit card debt, because you could get a 0% intro APR. If you have multiple types of debt, then you should get a personal loan.
You can make all your payments, but you don't have good credit
Use either the debt snowball or the debt avalanche method. Since the debt avalanche method saves money, you should choose that one if you're confident you can stay on track with all your payments. If you prefer a method that will keep you motivated, then go with the debt snowball.
You can't make all your payments
Contact a nonprofit credit counseling agency for assistance. It may be able to help you adjust your spending and free up enough money to make all your payments. If not, you can ask a counselor about negotiating a debt management plan or debt settlement.
