DEBT MANAGEMENT 101: Use Debt Wisely

Presented by: Alexa Glanzel, CFP^®

Contact Alexa: Direct 315-333-1315

Understanding the Cost of Debt

Principal: When you borrow money from a lender, you receive a certain amount called the principal. You agree to pay back that principal over time, usually through regular monthly payments.
Interest: When you borrow money, it involves a lender giving you money upfront. So, lenders charge you interest (the cost of borrowing money), which is a percentage of the amount you owe.
Monthly Payment: Whenever you borrow money from a lender, you are required to repay the lender over a period of time via monthly payments. Each monthly payment generally includes two parts:
- A portion that goes toward paying down the principal (the original amount borrowed).
- A portion that covers the interest (the cost of borrowing the money). As you make payments, your principal balance goes down, and the interest you owe each month usually decreases as well.
- Here’s the catch: Minimum monthly payments (the amount you are required to pay each month to the lender) often lead borrowers to believe that debt isn’t all that bad. If the monthly payment is manageable, why not take out the loan? Here’s why:
Interest adds up fast: The catch is that interest compounds—meaning if you don’t pay off your total debt balance each month, the interest you owe can get added to your balance, and next month you’re paying interest on a bigger amount (the original amount plus the unpaid interest). This can make your debt grow quickly if you only make the minimum required monthly payments. The longer you take to pay off debt, the more interest you pay, sometimes ending up paying much more than you originally borrowed.
Example: Imagine you have a $5,000 credit card balance with an annual interest rate of 24%, and your credit card requires a minimum payment of 2% of your balance each month.
1. In the first month, 2% of $5,000 is $100, so you pay $100.
2. However, the monthly interest on $5,000 at 24% APR is also around $100. This means that your entire payment goes towards interest in the first month, and your principal balance doesn’t decrease.
3. In the following months, since you didn’t reduce the principal, interest keeps adding up on the full $5,000. Even when the balance starts to lower slightly, much of your minimum payment still pays interest, with only a small part reducing the main debt (principal).
4. Because of this, it can take years to pay off the debt, and you end up paying thousands more in interest than you originally borrowed. For instance, with these terms, making only the minimum payment could take more than 11 years to clear the debt and cost you several thousand dollars in interest alone.

Prioritize High-Interest Debt

Using strategies like the ones below can help guide and motivate you towards paying off your debts in the most efficient way possible and avoid falling into the trap of minimum monthly payments.

Snowball Method: Allows you to focus on paying off your smallest debts first, which helps you eliminate some balances quickly, providing you with a sense of accomplishment and encourages you to keep going. This feeling of progress can be very powerful in maintaining momentum through what can be a long and challenging process of paying off debt. Here’s how you do it:
- Step #1: List your debts from smallest amount to biggest amount. For example, if you owe $200 on one credit card, $1,000 on another, and $5,000 on a loan, line them up like that — smallest to biggest.
- Step #2: Keep paying the minimum payments on all your debts except the smallest one. For the smallest debt, pay as much extra money as you can each month. The idea is to pay it off as quickly as possible
- Step #3: Once the smallest debt is fully paid, celebrate and take the money you were using to pay off that debt... and put it toward the next smallest debt. Because your first debt is gone, you now have more money to attack the next one faster
- Step #4: Repeat this process, paying off debt after debt, going from smallest to largest. The amount you can pay keeps growing like a snowball rolling downhill — that’s why it’s called the “snowball method.”
Avalanche Method: Allows you to focus on paying off your debts in order of highest to lowest interest rate. You make minimum payments on all your debts but put any extra money toward the debt with the highest interest rate first. Once the highest-interest debt is fully paid, you move on to the next highest, and so on until all debts are paid off.
1. Step #1: List your debts by the interest rate, from the highest rate to the lowest rate. For example, if you have one credit card charging 20% interest, another loan charging 10%, and a smaller debt charging 5%, you put the 20% one first.
2. Step #2: Keep paying the minimum payments on all your debts except the one with the highest interest rate. Put as much extra money as you can each month toward paying off that highest-interest debt first.
3. Step #3: Once the debt with the highest interest rate is fully paid off, move on to the debt with the next highest interest rate. Take the money you used to pay off the first debt and put it toward the second one, so you’re paying it off faster.
4. Step #4: Repeat this process, going down the list from the highest interest rate to the lowest, paying off debt after debt.

Avoid New Debt

Don’t borrow for wants—only for needs or investments (like education or a home). You should avoid new debt because taking on unnecessary debt, especially high-interest consumer debt like credit cards or personal loans, can quickly lead to financial stress, accumulating interest, and difficulty paying it off. This type of debt often costs more over time and can hurt your credit score, making it harder to borrow on good terms in the future. On the other hand, debt for homes or student loans is usually considered "good debt" because it is an investment in your future, often has lower interest rates, and can improve your financial situation over the long term. These loans help build wealth (through homeownership or education) rather than just funding current consumption.

Alexa Glanzel, CFP^® is a financial advisor at Weller Financial Group, located at 6206 Slocum Road, Ontario, NY 14519 and can be reached at 315-333-1315. Advisory Services offered through Commonwealth Financial Network^®, a Registered Investment Adviser.