Debt

Guide to financial independence part 2: how to manage your debt and improve your finances

Welcome back to our guide to financial independence. In our first post, we covered some of the most common terms you’ll find when dealing with your finances. Understanding these key terms is a great first step towards financial freedom, but what comes next? After basic financial literacy, one of the biggest hurdles in the way of achieving financial freedom is debt.

You’re not alone if you find yourself dealing with debt. According to the Federal Reserve Bank of New York’s Center for Microeconomic Data, total household debt in the second quarter of 2023 has reached over $17 trillion, with credit card balances increasing the most.

So, let’s dive into what debt is, how to manage your debt, and improve your finances.

Types of debt

Debt is any money owed to another entity—if you’ve ever had to borrow money, whether it’s from your parents or from the government, then you’ve experienced debt. Debt can come in various forms, both in terms of security and repayment plans.

Secured or unsecured debt

All debt is either secured or unsecured. Secured debt is backed by some form of valuable property, like your car or house, referred to as collateral. For example, a mortgage or an auto loan is a form of secured debt—if you stop making payments, the lender is legally allowed to seize whatever you’ve offered as collateral to repay your debt. On the other hand, unsecured debt has no collateral. These debts, like student loans or credit cards, don’t require collateral and instead rely on information like your credit score.

Sometimes there isn’t an option to choose between secured or unsecured—you can’t get a mortgage without offering the house you’re purchasing as collateral. That said, sometimes there are benefits to choosing one option over the other. The biggest benefit of unsecured debt is that you don’t have to put any of your valuables up as collateral. However, secured debts often offer lower interest rates than unsecured debts since there is less risk for the lender.

Revolving or installment debt

There are two main types of repayment structures: revolving debt and installment debt.

Revolving debt allows you to continually borrow and repay money up to a set amount, like a credit card or home equity line of credit (HELOC). In these instances, you can charge purchases up to your limit and then repay your balance, usually with interest. Revolving debts typically have a minimum monthly payment, so you’ll accrue interest only on the balance you carry. Installment debt comes from a loan that’s received in a lump sum, like your mortgage or student loans. Money is repaid with predefined terms, typically in equal installments with a fixed interest rate.

Is debt bad?

No—debt isn’t inherently bad. In fact, some debt is beneficial. Establishing a consistent record of on-time credit card payments can help you build credit, making it easier to obtain future auto loans or mortgages. Mortgages can also be considered “good debt” when they help you build equity.

Debt becomes bad when you can’t pay it back, like if you’re hitting your credit card limits regularly but can’t repay them. You should also beware of high interest rates or predatory repayment terms. Good debt can also become bad—paying your bills late or missing payments, for example, can be detrimental to your credit score.

What if my debt has already gone to a debt collector?

Currently, about 26% of Americans have debt in collections. This typically happens after you’ve missed three or more monthly payments.

The first thing you should do when you realize a bill has gone to collections is to reach out to them. Even if you don’t think you can repay it immediately, talking to the company will give you more information about the debt, and more importantly, confirm that it’s really yours. But don’t give out your information to anyone who calls about potential debt—scammers often pose as collectors in an attempt to steal your money.

When contacting or responding to collectors, you should first ask to confirm the information they have with a validation notice about the debt. They should provide this during your first phone call with them or in writing within five days after first contacting you. Additionally, collectors cannot lie, harass you, or treat you unfairly, as we’ll discuss more below.

How can I manage debt?

Whether you’re in collections or not, you want to be sure you’re appropriately managing your debt.

Take stock of your accounts

Your first step should be to review all of your accounts and list all outstanding debt. As you go, include the interest rate on each so you can determine which ones are causing you the most stress.

Check your credit report

Part of your review should be to request a free copy of your credit report from one or more of the three credit-reporting agencies to ensure you haven’t forgotten anything. It’s important that you’re also reviewing your reports to make sure there aren’t any accounts you don’t recognize. If you see accounts that aren’t yours, contact the lender right away to figure out if you’ve been a victim of identity theft.

Determine your debt-reduction strategy

Once you have a list of your debts and have confirmed them all, you’ll want to decide how you want to pay down your debt. There are multiple options for tackling debt, and you want to make sure you’re doing what’s best for your situation. One popular strategy is to pay off your debts with the highest interest rates first. With this strategy, commonly called the avalanche method, you save more money over the long run. The other most popular strategy is the snowball method, where you pay off the lowest balances first. This method is preferred when people need help seeing progress more immediately and can help you keep momentum over time. Regardless of your preferred method, both can help you make progress towards repaying your debt, so remember to be consistent.

Make a budget

Now that you’re on track towards managing your debt, stay ahead of future issues by creating a budget. List your monthly expenses, like rent or utilities, as well as your debt payments and any other expenses, like your streaming subscriptions, groceries, and entertainment. If you haven’t made a budget before, consider the 50/30/20 rule—divide your after-tax income into three categories: needs (50% of your income), wants (30%), and savings (20%). You may also check out financial wellness apps, like EveryDollar and Wally, to help you estimate your regular spending.

Need more help?

Having issues paying your debt? One of the best places to start is by calling lenders directly. You can often work out a plan to make smaller monthly payments. It’s important to remember that if you’re planning to contact them, you’re legally protected from debt collector harassment. When you talk to a debt collector, keep a record of who you’re speaking with and at what time. Ask for your validation notice, which confirms that the debt belongs to you and is in collections. If you don’t recognize the debt, there should be instructions included with the notice about how to proceed. If a collector threatens you or uses inappropriate language, hang up and file a complaint immediately with the Federal Trade Commission. It’s also possible to request the collector stop calling—you should report them if that debt collector still calls.

If you’re still struggling with your debt, consider reaching out to a credit counselor who can help you with a budget, develop debt management plans, and offer money management workshops. To find a counselor, you can check out the Financial Counseling Association of America, the National Foundation for Credit Counseling, or see of a list of approved credit counselors through the U.S. Department of Justice.

Key takeaways:

  • Debt is either secured or unsecured and can be borrowed and repaid in installments or with revolving debt.
  • Debt is not inherently bad, and some debt can be beneficial for your credit score. Debt becomes bad when you can’t repay it.
  • Request and review your free copy of your credit report yearly to ensure you’re up-to-date on all your debts and stay ahead of identity theft.

Debt is an inevitable part of life—whether you’re buying a house or car, applying for student loans, or signing up for the newest travel rewards card, you’re bound to experience debt at some point. In some cases, debt can be beneficial and help you increase your credit score. But when you’re struggling to repay your debt, that can take a toll both mentally and financially.

Do you have a tip for dealing with debt? Drop it in the comments below!

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