How to Pay Off Debt

Debt can be a powerful financial tool to improve your life or burdensome baggage that creates a drag on your financial well-being. Understanding how to handle debt, knowing the difference between “good” and “bad” debt, and having a strategy to pay off debt is essential to your financial wellness.

Personal debt in the United States totaled $14.6 trillion in 2021 — nearly $120,000 per household. The bulk of this is made up of mortgage and home equity loans, student loans, auto loans and credit card debt.

Other personal debt in the U.S. includes medical debt, personal loans, business debt and money owed to collection agencies.

Taking on debt is the only way most Americans can afford a home. But trying to pay off debt can drain your resources. That’s why you may hear about “good debt” and “bad debt.”

Good debt – such as buying a house – may improve your life in an important way or increase your net worth. Houses not only provide shelter and a home for your family, they tend to appreciate in value, giving you an investment toward your future net worth.

Bad debt involves loans you take out to cover purchases that quickly depreciate in value or have a high interest rate. Failing to quickly pay off a credit card purchase can sometimes turn into bad debt.

The key to determining whether something is good or bad debt often depends on your financial situation and how much you can afford to pay — and to lose — on the money you borrow.

Knowing your debt ratio is a good way to avoid getting too deeply into debt. Your debt ratio is the total value of your debt divided by your after-tax income. You can calculate this two different ways: with and without counting your mortgage.

This formula will tell you what percentage of your income is going toward paying off your debt.

As a rule of thumb, having a debt ratio of 10 to 36 percent is considered manageable — no higher than 10 percent if you don’t include your mortgage, 36 percent if you include it in your calculation.

Amounts higher than those are generally considered unmanageable by lenders. When your ratio hits 40 percent or higher, money lenders tend to consider you too risky for a loan. You’ll have a harder time applying for car loans, student loans and mortgages.

Americans paid off a record $83 billion in credit card debt in 2020. The COVID-19 pandemic spurred an unexpected surge in better personal budgeting and debt elimination. Staying home, spending less, and applying stimulus checks to credit card debt were credited with the turnaround.

But it was only the second time in 35 years that Americans ended a year with less credit card debt than they started with.

Paying off your debt requires a strategy. There are several different steps to take and multiple tactics to eliminating your debt. You’ll need to consider your spending habits and behavior, plan for emergencies that can create new debt, and understand your personal psychological challenge of facing and paying off debt.

There are several ways to get into seemingly unmanageable debt — medical emergencies, job loss or simply living beyond your income. But there are also resources — many of them free or at low cost — that can help you manage your debt.

Beware of scams that take advantage of people struggling with debt. There are two major types of these scams — advance-fee loans and credit repair scams. Many of these scammers use telemarketing schemes to reach people in debt.

Advance-fee loan scams guarantee that you receive a loan to pay off your debt — if you pay a scammer a fee up front. The fee varies but can run into several hundred dollars. Legitimate lenders will never guarantee a loan up front in exchange for any fee. Under federal law, a lender can only charge you a fee after you get the loan.

Credit repair scams promise to clean up your credit history for a fee. Mostly, their services consist of correcting inaccurate information in your credit report — something you can do yourself for free. If someone claims they can remove accurate — but negative — information about you, they’re lying and you’re being scammed. Federal and state laws prohibit that promise from being fulfilled.