How to Manage Debt
Borrowing money can help you get an education, buy a car, or finance a home. It also helps you earn the trust of the financial community. That trust can pay great dividends in your life—if you manage your debt responsibly.
Understanding How Much Debt Is Manageable for You
One cornerstone of responsible debt management is understanding what you can afford to pay for debt.
A first step toward this understanding is to add up your monthly income from all sources and then deduct essential expenses, such as food, housing, car insurance, and medical care. The amount left over is what is available for saving, for "discretionary" spending (such as movies, restaurants, cell phones, traveling), and for debt payments. For more help with budgeting see CollegeData's article 6 Tips for Managing Your Money in College.
The next step is to decide how much you want to save, how much you want available to spend freely, and how much you want—or can afford—to spend on debt payments every month. A simple spreadsheet or online debt calculator can help you experiment with debt amounts, payment amounts, and time required to pay off a debt.
If you already have debts, another useful exercise is to take a closer look at what you owe. Write down amounts owed, monthly debt payments, and interest rates. What you see might be an eye-opener. For example, you might see that one of your debts has a higher interest rate and decide to pay it down more quickly than others to reduce your borrowing costs.
Your Readiness to Qualify for Credit
You are not alone in your quest to understand how much debt you can manage. When banks or other creditors consider whether to offer you credit, they evaluate your risk as a borrower. They rely on information from you, your employer, your bank, and your credit reports to assess your credit worthiness in four areas:
- Capacity. What is your present and future ability to meet your payments?
- Capital. What is the value of your assets and your net worth?
- Character. How well have you paid your bills or debts in the past?
- Collateral. What property or assets can you offer to secure the loan?
If you are just starting out as a borrower, and don't have an extensive credit history, it might make sense to take steps to reduce your risk to lenders. Such steps include paying bills and making debt payments on time, putting money into a savings account, and maintaining a consistent source of income.
If you have never been issued credit, some lenders may evaluate your creditworthiness based on factors such as proof that you pay rent, utility, and phone bills on time, or that you make regular deposits to a savings or checking account. You could also ask another person, such as a parent, to cosign a loan. This gives you an opportunity to make payments on time and build your credit history. At the same time, the lender's risk is reduced because it can rely on the good credit of the cosigner. (The cosigner would have to pay what you owe if you didn't make the payments.)
How Using Credit May Help You
- Emergencies. Good credit can help you deal with unexpected expenses, such as car repairs.
- Big purchases. Having good credit helps you pay for expensive items over time.
- Employment. Employers often run credit checks on potential employees to determine how responsible they are.
- Rental housing. Landlords routinely run credit checks on potential renters.
- Car insurance. Your credit rating influences how much your premiums will cost.
- Interest rates. Your interest rate on a loan sometimes depends on your credit rating.
Understanding the Costs
of Borrowing or Using Credit
Yet another cornerstone of effective debt management is understanding that credit is not free—there is a cost. Lenders state the following charges in a clear and uniform manner so you can easily see the cost of borrowing money.
- Annual Percentage Rate (APR). The APR is the interest rate on your loan or credit card debt stated as a yearly percentage rate. It reflects the total cost of borrowing over one year. Some credit card providers may increase the APR if you do not pay your bill on time or if you exceed your credit limit.
- Finance charge. For loans, the finance charge is the total dollar amount the loan will cost you. For credit cards, it is the total cost of carrying a balance from one month to the next. There are different methods of calculating the finance charge, which should be documented in the card's disclosure statement.
- Total payments. This is the amount you will have paid after you have made all the loan payments, including interest, as scheduled. This amount could be more than you imagine, depending upon the interest rate and time to repay. The loan may still make sense for you, but it's important to understand the total cost of borrowing up front.
Understanding Forms of Credit
Finally, responsible borrowers understand that most borrowing comes in one of two forms:
- Credit cards. The moment you use your credit card for a purchase or cash advance, you are taking out a loan—even if you pay it off the same day. A credit card enables you to conveniently borrow money to make purchases and get cash—up to a maximum credit limit.
- Consumer loans. If you pay for anything "on time," such as furniture, jewelry, or a car, you are getting a consumer loan. You are expected to make regular monthly payments for a specific period of time, or term. Some loans are secured by property or other assets; if you fall behind on your payments, the creditor can claim the asset (for example, the car, if it's a car loan). Other loans are unsecured and are based only on your creditworthiness.
A Few Words About Student Loan Repayment
Student loans are an essential part of financing college for many students. After you leave school, however, it is time to pay back those loans.
Federal loans (and many private educational loans) offer several loan repayment options, including payments that are the same every month or gradually increase over time as your income grows. The standard repayment plan is a fixed monthly payment for up to 10 years. Other repayment plans offer terms of up to 25–30 years, depending upon the amount borrowed.
For federal loans, you are allowed a six-month grace period before payments begin—and you can get up to three years of loan deferment based on your income, student status, and other factors. Private loans may offer similar options. Be aware that the consequences of defaulting on a federal student loan are severe. Not even bankruptcy can let you off the hook.
Here's to Your Financial Health
Managing your debt is a little like managing a healthy diet. If you eat too much of the wrong kind of food, you risk your health. Eat too little of the right kind of food, and you risk lacking the strength to take important steps in your future.