Effective debt management

Debt often carries a negative stigma. But using debt responsibly can be an essential part of a comprehensive financial strategy — and help you to build wealth.

An Ameriprise financial advisor will help you understand how your debt fits into your overall financial picture and can affect your financial goals.

As you evaluate your current debts — or are considering financing a major expense — here’s what you need to know about effectively managing debt:

In this article: 

• Know how much debt you can afford 
• Understand the difference between good debt and bad debt
• Be smart about credit cards
• Use tried-and-true strategies to pay down debt faster
• Know when it makes sense to prioritize investing
• Make sure you have a cash reserve
• Build a budget to manage expenses
• Questions to ask an Ameriprise financial advisor

Know how much debt you can afford 

The key to managing debt is taking on only as much as you can afford to repay. 

One way to do that is to determine your debt-to-income ratio. To calculate this metric, tally all your minimum monthly debt payments — including your mortgage or rent and student, auto and other loan payments — and divide the total by your pre-tax monthly income. The result will be in the form of a percentage.

While there are no absolutes in determining desirable debt-to-income ratios, the following are general guidelines for how lenders evaluate potential borrowers:

Purchasing a home? Keep the 28/36 rule in mind

The 28/36 rule is a way lenders calculate the debt a potential homebuyer can reasonably take on. Under this guideline, a household should spend no more than:

• 28% of their pre-tax monthly income on housing expenses (including mortgage, insurance and taxes).
• 36% of their pre-tax monthly income on all debt payments (including housing). 

Understand the difference between good debt and bad debt

Like many things, debt is complicated. Too much debt can be a problem for some people, yet it can also help you reach your financial goals provided it’s managed responsibly. 

• “Good” debt is characterized as low-interest debt that helps you increase your income or net worth. Examples include educational loans, a mortgage or a business loan. Debt can also be considered good if it helps you build credit.
• “Bad” debt is characterized as high-interest debt that is used to purchase depreciating assets. Examples include using credit cards to buy clothing, furniture, or other goods that immediately lose value — then not paying off the balance and building up interest charges. 

Of course, too much debt can turn good debt into bad debt. And many kinds of debt don’t fall into either category since it will depend on your financial situation or other factors. 

• Learn more: How to plan for a major purchase 

Be smart about credit cards 

Credit cards offer a host of benefits. They’re convenient. They build a credit history. And they can be a helpful tool for tracking your spending.  Most credit cards also provide various security features, including liability protection for fraud or even travel and rental car protection. 

For all their benefits, however, credit cards are a less-than-ideal way to borrow money, as they carry high interest rates on any balances you don’t pay off right away. To avoid those high fees: 

• Only charge what you can pay off each month. 
• Keep your monthly charges to 20% or less of your maximum credit limit.
• Always pay your bill on time.

Use tried-and-true strategies to pay down debt faster

While paying off debt may seem overwhelming at times, there are practical measures to accelerate your repayment schedule or reduce the amount of interest you’re paying. Loan consolidation, the avalanche method and the snowball strategy are all approaches that can help you tackle debt effectively.

• Learn more: 6 tips to pay off debt and save money 

Know when it makes sense to prioritize investing versus paying off debt

The psychological benefits of being debt-free are undeniable. However, if you’re behind on your retirement savings or if you have an especially low interest rate on a mortgage loan, it may not be beneficial — from a pure numbers standpoint — to prioritize paying off your debt, compared to the returns you could make in the market. Additionally, certain debts — such as mortgages, home equity loans and student loans — offer tax benefits, so be aware of how that dynamic affects your overall financial picture.

It will depend on your unique situation and what you value most. For some, the sense of freedom that comes from no loan balance is worth more than the potential returns had they invested. Reflect on your priorities, run the numbers and be comfortable with any tradeoffs you’re making.

• Learn more: Pay down your mortgage or invest? 3 steps to help you decide

Make sure you have a cash reserve

Even if your priority is paying down your debt, consider setting aside a portion of your monthly income for a cash reserve or emergency fund. This pool of money can act as a cushion, potentially preventing you from getting deeper into debt if you face an unexpected expense.

• Learn more: How to establish a cash reserve

Build a budget to manage expenses

A big part of debt management is knowing how to avoid debt. Creating a household budget — and sticking to it — will help you stay on top of debt payments and systematically save for other goals.

•  Learn more: Creating an expense management strategy

Balance debt with your other long-term goals

Whether you’re rethinking how to manage your current debts or considering taking on new loans, an Ameriprise financial advisor will help you understand how it affects your broader financial picture.