When dealing with debt, it's important to recognize that there are various types and they won't always result in the same outcome. For example, going into debt for school or business purposes or taking out a loan for real estate (such as a mortgage) could be considered investments that might yield greater financial earnings for you in the future. This kind of debt may be costly in the short term, but could potentially end up paying for itself in the long term if it's an investment in an asset such as education or real estate. However, debt that does not invest in anything is simply a financial burden in both the short term and the long term. This is the kind of debt that must be managed carefully to avoid letting it quickly spiral out of control.
No matter how much or what kind of debt you take on, it's essential to have a solid repayment plan. Since interest compounds over time, the amount you have to pay off can quickly get out of hand. When handling debt, it's always best to pay it back as quickly as possible.
The Power of 50
This financial formula helps you pay off your debt faster. Let's say that you have a $3,000 debt at an annual interest rate of 18 percent. If you make the 2 percent minimum monthly payment of $60 per month, it will take you eight years to pay off your bill – assuming you don't continue to spend any more money during that time. By the end of the eight years, you will have paid $5,760 – almost double the initial $3,000. By paying an additional $50 per month, you can pay off your debt in three years instead of eight, which saves you over $1,800 in interest. The bottom line: paying off your debt sooner rather than later saves you money.
The 28/36 Rule
Another helpful guide is a rule mortgage lenders use: the 28/36 rule. It stipulates that your housing payments shouldn't exceed 28 percent of your gross monthly income, while your total debt service – including your house payments, utilities, credit cards and other loans – shouldn't be more than 36 percent. Housing loans from organizations like the FHA, VA or USDA may allow an even higher debt to income ratio but it is good to keep in mind that the higher the ratio, the greater likelihood of a higher financial stress level.
Types of Loans