Getting in debt isn’t the end of the world but these worst debt mistakes could ruin your financial future
Everyone gets into a little debt sometime in their life. The average American household owes $16,000 in credit card debt and over $132,500 when you include mortgage loans.
Debt is a financial tool. Like using a hammer, it can be used to build something you couldn’t otherwise.
Use it incorrectly though and you’ll smash things up something fierce!
That’s why I reached out to 16 money experts to find out, “What are the worst debt mistakes you can make?” These aren’t the simple mistakes like spending a little too much here and there but the mistakes with debt that could put you in the poorhouse.
Understanding these debt problems will help you use debt correctly, pay it off faster and maybe even avoid it altogether.
Mistakes People Make Before Getting in Debt
Grant of Millennial Money starts us off with the difference between good debt and bad debt.
Most people assume that all debt is bad, but it's not. Smart leverage, especially when it comes to real estate, is a wise choice. Also, many people try to pay down debt, when it might make more financial sense to invest that money with higher growth potential.
A lot of people try to pay off their mortgage when their rates are below 4% and they would get a much higher ROI investing that money in an index fund long term with a higher expected rate of return. In that case, it makes sense to keep some debt on your home and take advantage of longer term stock investing opportunities.
There’s two great points here.
- Not all debt is bad. Without a mortgage loan, few people would ever be able to afford to buy a home.
- Don’t wait to be debt-free to start investing. Pay off high interest debt but get started on your long-term financial goals as well.
While there is such a thing as good debt, most people may need to change their mental mindset when it comes to taking out credit. Aaron of Three Thrifty Guys explains:
I think one of the biggest debt mistakes we all make is taking it (debt) on too easily. It’s so easy to think, “Oh, I’ll pay it back at the end of the month,” and to not worry about the amount of credit we’re racking up.
There isn't much pain with taking on debt today so we don't “feel” it like we once did when we had to hand over the cash. This causes people to spend more and save less.”
For those loans you really do need, give yourself a month or two to improve your credit score. This is going to give you a little more time to think about the loan and make sure payments will fit in your budget. It will also help get you a better rate and save money on interest.
Before filling out an application for credit, be sure to check your credit score in addition to your credit report. If your score is too low or contains errors, your application may be denied automatically.
There are ways however, to boost your score and get errors removed from your report. You should also research lenders and banks for the terms and conditions of the credit being applied for. They do vary and you can save yourself some money in the process.
One rather surprising fact about bad credit is that it can be fixed. There are steps you can take to boost your score. While your credit may be bad across the board, it may not be as bad depending upon which score you use. There is more than one.
Generally, shopping around for a loan won’t hurt your credit score. Many lenders will do a soft inquiry first to approve your application and estimate an interest rate. Compared to a hard inquiry which doesn’t come until your loan application is processed, these initial credit report checks won’t affect your score and you can use them to find the best rate on a loan.
Don’t Avoid Debt and Hope it Will Go Away
So now you’ve got some debt, actually it’s piling up fast and you’re almost afraid to open the mail.
Jen of Saving with Spunk warns that avoiding your debt could be one of the worst debt mistakes you could make.
The biggest mistake I see people making with debt is ignoring it. It's easier than ever to finance cars we can't afford, get credit lines for more than we need, and to put student loans in forbearance indefinitely. Once you rack up huge amounts of debt, paying it all back can seem hopeless so people ignore it.
Interest doesn't stop just because you quit looking at the bill. You should be actively prioritizing paying down your debts. If circumstances make it so you're unable to attack it aggressively, making minimum payments or paying at least the accruing interest every month will keep you from sinking deeper into a debt hole.
Fortunately, once you’ve resolved to face your debt head-on, there are lots of ways you can pay it off.
How to Plan Your Debt Payoff for Success
You can’t attack your debt without a plan. Debt is sneaky, only making you pay off a small amount each month while the interest piles higher.
If you really want to pay off your bad debt and get out from under the burden, learn how to prioritize and plan your debt payments.
Physician on Fire recommends prioritizing debt payoff by interest rate in a method known as the avalance.
People straddled with debt tend to treat all debt the same. The ever-popular “snowball method” does this, ordering your bills by balance for extra payments to the smallest first.
The most efficient way to approach debt is to consider not only the balance, but also the interest rate and the potentially favorable tax treatment of each debt you owe.
- High interest debt should be high priority for payoff regardless of the balance. That usually means paying off the credit cards first.
- Consider some debts, such as mortgage and student loan debt, may have tax-deductible interest depending on your tax bracket. The effective interest rate after the deduction may be much lower than the stated rate you pay.
While the avalanche method of paying off higher rate debt first will save you money, consider the snowball method if you’re having trouble sticking to your budget. Paying off the smaller debts and watching them drop from your list can be a great motivator, just don’t forget to attack those high-interest credit cards as well.
A lot of people get discouraged paying down debt because they don’t have much extra each month and don’t think it will matter. Zina Kumok of Debt Free after Three shows how she was able to turn just $10 a month into big-time savings.
A lot of people don't realize that even small changes can minimize their debt. I started paying off my loans by adding an extra $10 a month – that shaved off one year off my 10-year term. If you can only do an extra $25 a month, that's fine. Start small and increase when you can.
In fact, adding just $15 a month to your mortgage payment can save you over $5,700 in interest on a 30-year loan and pay it off years early. Consider bi-monthly payments or adding more for even bigger savings.
Taylor of Stay Wealthy San Diego shares a great idea to put your debt payoff on auto-pilot.
Debt can be paralyzing. Often times, it looks so big that people only make the minimum monthly payment and nothing more. They figure they will just wait for an influx of money sometime in the future to help chip away at it. That's a HUGE mistake!
I don't care how much money you owe. Pick an amount – above and beyond the minimum payment – that you can commit to on a monthly basis and set up auto-pay.
Even if it's $50 extra per month, you will have reduced your debt by $600 at the end of 12 months. That's $600 less debt than what you started with and can feel like a big win. One win is sometimes all the motivation you need continue tackling your debt head on until it's gone forever.
Even with the best debt payoff plan, you’re bound to hit snags along the way. One of the worst debt mistakes you can make is to give up and set yourself back with new debt on top of old.
Dealing with the Worst Debt Mistakes
One of the biggest hurdles to keeping a debt payoff plan is just not having a solid plan to start.
Without a crystal clear plan, Devin of Social Security Intelligence warns that you risk a month or two of ‘doing good' only to be derailed by another emergency or an ‘excellent' deal that sidetracks you and adds more debt.
Instead, a clear cut plan with defined steps and timelines will help keep them focused and make it easier to deal with the inevitable setbacks.
- Visualize what you’ll be able to do without the burden of those debt payments.
- Set realistic goals for how much extra you can pay each month without cutting your budget to the bone and not enjoying life a little
Lauren of Financial Best Life says paying off debt is HARD work.
Many don't anticipate how much cutting back on the budget to pay off debt takes it's toll. This is why I recommend people set rewards in advance when they meet certain debt pay off milestones…just remember to “treat yourself” with no more than 5% of the balance you just paid off. Do it responsibly and guilt free!
Also, don’t forget to put some money in savings for an emergency fund. One of the worst mistakes people make with their debt payoff plan is not saving money back for ‘life happens’ moments.
Without an emergency fund you might have to turn to the cards again when unexpected expenses come up, setting you back to fight your debt all over again.
Howard Dvorkin, Chairman of Debt.com says lack of an emergency fund is the worst mistake he sees people make.
Obviously, no one wants to think about suffering a painful illness or accident, getting divorced or laid off, or losing our possessions in a natural disaster. Yet those are – hands down – the five major causes of catastrophic debt in this country.
Even so, few of us have an emergency fund, because we simply don’t want to set aside money for something that might never happen. Then when misfortune comes our way, we can’t recover – sometimes for years, sometimes forever.
Let the insurance lapse on your house and a fire could wipe out hundreds of thousands. Neglect paying your health insurance and an illness could bury you in hospital bills. Believe it or not, failure to put aside a little in an emergency fund can be just as bad or worse!
Think Long-term to Ditch Your Debt
It’s easy to look at the low monthly payments on credit and think a little more debt is no big deal. This kind of short-term thinking gets people into a lot of financial trouble.
Ditching your debt and avoiding some of the worst mistakes means thinking long-term and how that debt affects your future.
James of Saving Advice shares his own worst debt mistake, one that still haunts many homeowners.
The absolute biggest mistake I've made with debt was taking out an option adjustable rate mortgage (ARM) back in 2008. The bank kept raising the monthly fee by $50 or so every month. I had to spend $4,000 to refinance to get out of that loan.
Lower initial rates on variable-rate loans may look tempting but can come back to bite you in the long-run. Another doozy are interest-only loans where you pay just the interest for years and then have to refinance or start making huge monthly payments.
Interest adds up, especially when you aren’t paying down your loans every month. Deferred payments are considered a great advantage of student loans but Tim of Next Gen Personal Finance suggests at least paying the interest as it accrues.
Most students don't realize that they can make student loan payments while in school. Doing this will not only help them establish a credit history but also will keep the interest from being added to their unsubsidized loan.
As for the cost, a $5,000 student loan with a 3.76% interest rate, would result in interest payments of about $16/month. The benefits to building a great credit score when you graduate will far exceed that monthly cost!
Rocky of Richer Soul warns borrowers about this compounding of interest and how it can get out of control.
Borrowers don't realize debt compounds just like investments do and the force of compounding is pretty powerful. At an annual rate of 14% and compounded monthly, debt doubles in just five years. That means a $10,000 loan becomes $20,000 if regular payments aren’t being made.
Over time the debt can grow and when something goes wrong the debt snowballs into a large sum that can no longer be manageable.
In fact, making just the minimum payments on a credit card with 14% APR on a balance of $16,000 could mean paying more than $18,000 in interest over 29 years.
Changing Your Money Mindset about Debt
You can put together all the debt payoff plans you want but you’ll never be truly debt free until you change your money mindset.
That doesn’t mean you have to become a total debt agnostic but it does mean stepping back and rethinking what it means to be ‘in debt’.
Melissa of Sunburnt Saver challenges the idea that debt is a part of life.
The worst debt mistake people make is thinking “everyone has it”, especially when it comes to student loan debt. That's a mistake! People may have debt, but that doesn't make it okay or an unavoidable fact.
If you do have debt, first, don't be too hard on yourself. The American education system (and, yes, parents) do a terrible job educating young Americans on personal finance and debt, so many of us go into situations thinking debt is okay and not understanding what “being in debt” means.
However, once you've realized you're in debt, stop putting yourself in more debt. It's hard to cut up the cards or put yourself on a budget, but debt is not just a part of life.
There’s a reason why the words ‘debt’ and ‘burden’ are used so frequently together. While I believe some debts like mortgage and student loans can be acceptable, there’s one type of debt that accounts for the biggest problem with most borrowers.
Josh of Finance Footing warns against one of the worst debt mistakes, using credit cards to buy things you can’t afford.
People end up paying three- or four-times the price of the item in credit card interest. Why do they do it? It's either impatience or trying to impress others with material objects. If you can fight that human behavior, you are much better off.
Jon of Financial Independence Hub offers an idea to avoid racking up high-interest credit card debt.
Credit cards and high-interest consumer debt is simply a wealth destroyer that can be easily avoided by paying card balances off in full every month, and NOT paying only the suggested minimum monthly payment.
If you need a credit or card or two for convenience and a paper trail, then pretend they're a debit card and pay off the balances during the grace period before any interest is charged.
Vanessa of Cash Cow Couple warns against any type of high-interest consumer debt as detrimental to financial success and well-being. “The ongoing interest and fees can destroy your ability to manage monthly cash flows and prevent you from reaching your most important financial goals. Outside of a student loan or a mortgage, there should be little reason to go into debt at all.”
Debt doesn’t have to trap you like it has so many others. Avoiding the financial ruin that comes with bad debt and being able to use good debt as a tool means understanding some of the worst debt mistakes made by borrowers and how to manage financial leverage.