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Taking Charge of Your Debt

8231671430_e83d55aa51If debt is hampering your ability to pursue your financial goals, consider these debt management strategies:

  • Get a handle on your debt. List all your debts and monthly payments, listing the debts from highest to lowest interest rates.   Then calculate your debt ratio, which equals your monthly debt payments (excluding your mortgage) divided by your monthly net income.   The general rule of thumb is that this ratio should not exceed 10% to 15% of your net income.   Yet don’t become complacent if your debt is in this range.
  • Watch your credit card debt closely.   Credit card balances typically carry higher interest rates that are not tax deductible.   The best strategy is to only use credit cards if you can pay the balance in full, thus eliminating interest payments.  If you can’t manage that, at least make sure to pay more than the minimum payment.   If you carry a balance on your credit card, call the company and ask for a lower interest rate.   Those having difficulty controlling credit card purchases should consider more drastic measures, such as refraining from using credit cards until debt is under control.
  • Don’t prepay your mortgage unless all other debts are paid in full.   In general, interest paid on mortgages with balances of up to $1,000,000 and on home-equity loans up to $100,000 is deductible on your federal tax return, provided you itemize deductions.   Also, interest rates on mortgages and home-equity loans are typically lower than rates on other consumer debts.   Thus, you should pay off your consumer loans before paying down your mortgage.   Start by paying extra on the card with highest interest rate.  Once that debt is paid in full, move on to the next highest interest rate, continuing until all your debt is paid in full.
  • Be cautious when using a home-equity loan to pay off consumer debt.  While in theory it is a good strategy to replace higher interest consumer debt with a lower-interest home-equity loan with tax-deductible interest, the danger is that you will just run up your consumer debts again.   Only use this strategy if you make sure not to overuse your credit cards again.
  • Work on your spending habits.  You’re probably in this situation because you have trouble controlling your spending.   Put yourself on a budget and stick to it.   Look for ways to reduce spending so you’ll have more money to pay down debt.
  • Compare interest rates at several lenders.   Interest rates can vary significantly among lenders, so periodically review all your debt to see if less-expensive options are available.
  • Don’t purchase items on credit that don’t appreciate in value.   Use cash for items like clothing, vacations, entertainment, and dining out.   Most people find it harder to spend cash than to charge a purchase on a credit card.   Hopefully, that will cut down on your spending; but if not, at least you won’t be paying interest on top of it.
  • Consider using savings to pay off consumer debts.    Since you don’t get a tax deduction for interest payments on consumer debts, paying off a credit card balance with an 18% interest rate equates to a 24% pretax return for those in the 25% tax bracket.   If you aren’t earning at least that amount on your savings, use it to pay down your debt.

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