Being in debt isn't a whole lot of fun. And it can also be a big financial disaster, depending how much you owe and what kind of debt you have. The good news is that there are proven methods to pay down debt -- but the bad news is you have to get serious about debt repayment if you really want to become debt-free.
If you aren't currently working on a debt payoff plan, here are four good reasons why you should definitely start paying down your debt now.
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1. You're wasting money on interest
Debt is almost never free -- you have to pay interest when you borrow. These interest costs can really add up, especially if you pay only the minimum on credit card payments. In fact, if you borrowed $5,000 on a card at 15% interest and paid a minimum payment equal to the lesser of 2% of your balance, or $10, you'd end up paying $7,789.37 in interest charges. And you'd be paying that balance off over more than three decades!
While this is an extreme example, interest is almost always costly on consumer debt. Even a $30,000 car loan at 4% paid off over 60 months would cost you more than $3,000 in interest. This is more than 10% of the cost of the car, assuming you financed the full purchase price. The longer you carry debt and the higher the interest rate, the more you'll pay over time.
If you don't want to make every purchase cost more, work on paying off your debt ASAP. After all, don't you have better things to do with thousands of dollars than sending the money to banks or credit card companies?
2. Your debt is making money management harder
Most debts are paid on a monthly basis. When you have credit card bills, car loans, student loans, personal loans, and other debts to pay, all these monthly payments take up a big percentage of your paycheck. This leaves you with less money to do other things -- like purchasing the essentials, saving for college or retirement, or working toward accomplishing financial goals such as buying a house.
If you can pay off your creditors, all this money you were sending to debt payments would be yours to keep. That $30,000 auto loan at 4% interest over 60 months, for example, would cost you around $552 per month. If you invested $552 monthly over 30 years instead of sending it to a car loan lender, you'd end up with over $670,000 if you earned a 7% return on investment. That's a pretty nice retirement nest egg you could build if you weren't stuck sending that money to a lender every month.
3. Your debt is dragging down your credit score
When your credit score is determined, your credit utilization ratio is taken into account. This is the amount of credit you've used versus the credit available to you. A person with a $1,000 balance with a $10,000 credit limit is using 10% of available credit, so he or she has a credit utilization ratio of 10%.
A credit utilization ratio above 30% is a red flag because it indicates you may be too deeply in debt and not able to manage your payments effectively. A lower utilization ratio, on the other hand, can boost your score big-time. By working on paying off credit card debt, you can reduce your credit utilization ratio, and your credit score should go up as a result of your efforts.
Your record of on-time payments that you make while working on debt payoff should also help you earn a better credit score. And, since employers may check your credit along with auto insurers and other companies you do business with, having a good credit score is really important.
4. Your debt could make it harder to borrow for important things
While you want to borrow as little as possible to avoid owing interest, there are times when borrowing is necessary -- and even makes financial sense.
If you need to borrow to grow a business or pay for college, this investment in yourself could pay off by significantly increasing your income. And most people need to borrow to buy a home, which can be a good thing, since homeowners tend to have a higher net worth than renters.
Unfortunately, if you have a lot of debt, it will be harder to get approved for loans that actually help you accomplish worthy goals. That's because most lenders look at your debt-to-income ratio, which is calculated based on your debt relative to your income. A debt-to-income ratio that's too high could result in a loan denial or you could be charged a higher interest rate if you're allowed to borrow at all.
By paying off your debt, you can lower your debt-to-income ratio so lenders view you as a less risky borrower. This would enable you to get loans on good terms when you really need them.
Start working on your debt payoff plan today
As you can see, working on debt pay down is very important -- and it isn't something that can wait. So, make a plan today to allocate extra money to paying debt; figure out which debts you want to pay off first; and start working on becoming debt-free. When you accomplish your goal, you'll be very glad you made the effort -- especially as you start to do big things with all the money you're saving on interest.
