The longer we take to pay off bad debt, the more it costs us and that means the more it holds us back from doing the things we really want in life. So, if there’s room in our budget and we have got even a little bad debt, it’s a smart move to put more towards getting rid of it before looking at anything else such as building up savings or investing.
Differences in interest rates
Understanding differences in interest rates might seem intimidating at first, though it’s immensely helpful when choosing a debt payoff strategy. There are two quite different types of debt:
As the name suggests, secured debt is a loan that’s secured by an asset, like our home, car, or a business. In the case of default, the lender has the ability to seize that asset as a form of repayment for the loan. Because secured debt poses less risk to the lender, these loans often come with lower interest rates than unsecured debt. We’ve likely heard of secured debt in the form of a car loan, where the dealer can repossess our car if we fail to make on-time payments.
Alternatively, unsecured debt is not secured by anything; the borrower is just contractually obligated to repay the debt according to the loan agreement. If we default on an unsecured loan, the lender can report our nonpayment to credit bureaus and take us to court to enforce repayment—but they can’t repossess whatever we may have purchased with the loan. Credit cards and most personal loans fall into the category of unsecured debt.
What is bad debt?
High interest “bad” debts are one of the worst wastes of money. Most financial gurus consider the following to be examples of bad debts:
Payday loans. These are small, short-term, often high-interest loans.
Credit cards. Whether issued by a bank or a specific retailer, credit cards can be a great way for disciplined people to cover everything from one off purchases to recurring monthly charges and even emergency expenses. Though if they’re not repaid within the interest free period, credit card debt is bad debt with interest rates as high as 25%.
Car or vehicle loans. Often come with mid- to high interest rates.
Loans for consumer goods such as electronics.
Personal loans. These come in many shapes and sizes, but they nearly always come with mid- to high interest rates.
Any other debt with a high interest rate, especially when used for discretionary expenses or to buy things that lose value.
Though just like many things in life, it’s not always easy to clearly define “good” versus “bad” debts. An often-used example of this is taking on debt to buy an economical vehicle to get to and from work – many of us might consider this to be a good debt, as the car will help the person earn more than if they didn’t have it.
Sometimes a bank or other lender can combine several different high-interest loans into one lower-interest loan.
A single payment can be a lot easier to manage than multiple ones, and it might mean saving a lot of money by paying less interest. This is called debt consolidation. However,… repaying a new loan over a longer period could cost more overall, even if the interest rate is slightly lower. Some debt consolidation loans come with even higher interest rates than the debt they’re replacing!
Whatever the case, the trick is to keep paying these sorts of bad debt as fast as possible – and avoid racking up any new debts along the way.
How to repay bad debt, quick
1. Debt snowball
List your non-mortgage debts from lowest balance to highest balance. This could include car repayments, or a credit card.
Pay the minimum payment on all debts except the one with the smallest balance.
Throw every cent you can find at the smallest debt.
When that debt is gone, do not alter the monthly amount used to pay debts, but pay all you can toward the debt with the next-lowest balance.
2. Debt avalanche
List your bad debts from highest interest rate to lowest. Unlike above, with the debt avalanche you then pay off the debt with the highest interest rate first.
The logic behind the debt snowball method is based on gaining the mental advantage of having less debts to repay, while the debt avalanche works fastest mathematically. Naturally, you can choose whatever method you prefer based on what might work best for you.
Secured debt – one more thing to consider
Even though secured debt might come with a lower interest rate than unsecured debt, to eliminate the risk of a lender repossessing our car, it could be a solid move to repay these sorts of loans first.
Struggling to make payments?
If it gets hard to keep up with debt repayments, talk to the person, business, or organisation that lent the money as soon as possible. They may be able to work out a new repayment plan. There’s also free budgeting and debt advice from plenty of services up and down the country. These sorts of services can even be used anonymously.
Moneytalks is one example, or just search online for “Budget adviser”.
For the avoidance of doubt, here at Milestone Direct we have a highly qualified team of Financial Advisers who can help with a range of financial solutions, including areas such as investments, retirement planning, lending, and personal insurance. This is quite different to a budget advisory service, who are usually charitable and/or taxpayer funded organisations which focus on getting people back on their feet financially, including with budgets and getting out of bad debt.