IF YOU ARE WELL above the debt ratio used by lenders, which means you’re devoting more than 36% of your pretax monthly income to servicing your debts, there’s a good chance you have borrowed too much. But you probably don’t need the debt ratio to tell you that because it’s already painfully obvious.
What to do? The first step is to put yourself on a cash diet, which means not spending more than you earn and avoiding all new borrowing. Next, start to tackle your debts. Focus on paying down your highest-cost debt first, which will likely be your credit card balances.
You might, however, take a slightly different approach if you have, say, student loans or car loans that are almost paid off. If you can get those paid off quickly, it might substantially improve your monthly cash flow, and then you can focus in earnest on paying off those credit cards. This strategy of focusing on paying off the smallest debt first, and then moving on to the next smallest debt and so on, is sometimes called the “snowball method.” If you have federal student loans, you might also investigate the federal government’s income-based repayment programs, which could lower your monthly payments.
Another possibility: If you have built up some home equity, consider setting up a home equity line of credit or refinancing your current mortgage. Either way, you could borrow against your home’s value and use that money to pay off higher-cost debt. If you’ll struggle to cope with the resulting monthly mortgage payments, refinance with a 30-year mortgage rather than anything shorter.
Keep two caveats in mind. First, while extending the length of your mortgage should cut your monthly payments, it also means paying more interest over the life of the loan. Second, under the 2017 tax law, interest on home equity loans and lines of credit is no longer tax-deductible.
You might also investigate other ways to consolidate debt, such as borrowing from your 401(k) plan or cash-value life insurance, and using that to pay off higher-interest debt. You might even apply for a bank loan, though you may find it difficult to qualify if your finances are in rough shape. In addition, you might investigate refinancing other loans, such as car loans and student loans. As with a mortgage, if you extend the life of these loans, you could reduce the required monthly payments.
Finally, steer clear of debt-consolidation companies or other firms promising to help you pay off your debts. All too often, their loans come with exorbitant fees, high interest rates and other drawbacks. What if your debts are so great that you can’t see any way to get yourself back on track? It may be time for more drastic action.
Next: Overwhelmed by Debt
Previous: Invest vs. Reduce Debt
Blog: My $88,000 Nightmare