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Henry MolinaWritten by:
Henry Molina
Lafayette Federal Credit Union
Vice President, Business Development

Establishing and sticking to a budget is one of the best ways to stay on top of your financial health. Whether you’re just beginning to build credit or have already taken on some debt, building a budget to stay on top of your finances and manage debt repayment is the key to success.

The average debtOpens in New Window among American consumers in 2021 was $92,727, which includes credit card balances, student loans, mortgages, and more. This number can represent a large chunk of your finances, so budgeting (especially the way you manage your debt) should be a priority in maintaining a healthy financial well-being. An effective budget allows you to make better spending decisions and can highlight where you can cut expenses to allocate extra money toward paying off debt.

How You Manage Debt Will Impact Your Credit

You may have heard debt being classified as either good debt or bad debt. Typically, when you hear good debt, it’s in reference to money borrowed at a low, fixed interest rate to purchase assets that may increase in value over time. A mortgage or business loan often fall under this category.

Debts that are labeled bad are the opposite. They tend to be high-interest loans or credit cards used to buy things that are quickly consumed or lose value once purchased.

Ultimately, whether or not you get yourself in over your head with debt is often determined by your behavior in regards to spending and managing money, rather than any one type of debt you incur. A few good rules of thumb to support a healthy credit history and score are:

  • Build a budget to pay off debt
  • Keep your credit card charges to a minimum
  • Pay your credit card balance in full every month
  • Make your debt payments on time, all the time
  • Do not utilize more than 30% of the credit you are approved for

If you don’t establish and stick to an effective money management plan, poor habits will likely impact your credit and may affect your ability to borrow, rent, or even get a job. Sub-par credit will also make any loan that you do get approved for more expensive, as interest rates rise if your credit score is low.

Make Payments on Time

Sticking to your budget can help you stay on track with your monthly obligations. Making payments on time is the most important factor in calculating your credit score. Once a payment is more than 30 days late, creditors can report you to the credit bureaus, which can negatively affect your credit score.

If all of your monthly payments are accounted for in your budget, it is less likely that you will miss or forget to make one. To ensure your payments are made on time, consider setting up automatic payments for your credit card and loans through your bank or credit union. By doing so, you can rest assured you make your payments on time without having to remember each one every month.

Utilize Credit Responsibly

Be mindful of your credit utilization rateOpens in New Window, which is the amount of revolving credit you're currently using divided by the total amount of revolving credit you have available. For example, if you have three credit cards with a total credit limit of $15,000 and you have charged $9,000 worth of purchases, your credit utilization rate is 60%.

A best practice is to get your utilization rate below 30% to improve your credit. For excellent credit ratings (usually scores of 800 or above), the standard is 10% and under. A high credit utilization rate will impact your credit rating and may cause lenders to either deny your application or charge a higher interest rate to borrow money.

Budgeting is Your Best Tool to Pay Off Debt

In the simplest terms, a budget is a detailed accounting of all your income and expenses. There are formulas, templates, and apps you can use to get started, so choose a system that works for you and stick with it. You can do an online search for budgeting tools, and you’ll see there are many options available to work with.

Create Your Budget

All budgeting tools use the same basic methodology which requires you to input the amounts and sources of all your monthly income and expenses. Notating each transaction will help you become aware of how much is coming in and going out, as well as pinpoint any adjustments you need to make.

Through the budget process, you may discover that the way that you’re managing your money is not moving you toward your financial goals. You may realize you are spending frivolously on certain things - the sooner you can identify these types of transactions, the sooner you can make a change. The average consumer spends at least a fraction of their income on unnecessary items.

If you’re not staying on top of your finances, it can be easy to buy things you don’t needs. Being on top of your budget can be the key to resisting unnecessary spending and empower you to only purchase things you need or truly want.

Assess What You Owe

Once you’ve got a good understanding of your financial picture, you can then focus on your financial obligations. Write down all your debts (i.e. loans), including mortgage loans, auto loans, student loans, medical debt, credit cards, and home equity lines of credit.

You must account for all of your debts on your budget and continue to pay as agreed on every obligation. From there, you can strategize what debt you want to target first and pay down as aggressively as possible.

Plug in the Numbers

Create a list of your debt accounts and include the current balance and the Annual Percentage Rate (APR), then add them to your budget document. List them in order of either largest to smallest APR or smallest to largest total balance owed. Depending on the list you made, you will use it to create a debt repayment strategy (see below).

When you’re done listing out all income, expenses, and debts, you will have compiled a good snapshot of your current finances.

It may cause some anxiety if you see that you’re spending more than you make each month or realize that you owe more than you thought. If this is the case, don’t worry; you’re not alone. Once you’ve completed the budget exercise, you’ll be set to take control of your finances.

Set Financial Goals

Take some time to set goals for what you would like to accomplish financially and then use your budget to help achieve them. Assign any available funds to help you move toward those goals. Goals should be specific and have a timeline, such as:

  • Pay off all credit card debt in the next 24 months
  • Set up a monthly automatic transfer of $250 from checking to savings toward a $5,000 emergency fund
  • Commit $150 monthly to invest toward retirement

Setting financial goals boosts motivation for making the sometimes difficult habit changes needed to move in the right direction. Build these goals into your budget. Include them at the bottom of your working budget document, so that when you find yourself with extra money at the end of the month, you know where to allocate it.

Building Debt Repayment into Your Budget

Now that you have a budget in place that includes a list of debts to pay off, you can choose a debt repayment strategy that best helps you to achieve your goals. There are two popular options detailed below. But first, let's talk about minimum payments on credit cards.

Strive to Pay More than the Minimum Amount Due

Paying the minimum amount due will help you avoid late fees and dings on your credit, which is important – but it usually isn’t enough to overall decrease your debt.

By paying only the minimum monthly payment on a loan or credit card, you’ll continue accruing interest and it will take a lot longer to pay it off. The table below demonstrates the difference between paying a minimum payment of $25 on a $1,000 credit card balance vs. increasing your monthly payment up to $100 on that same card.

As you can see, making the minimum payment on this card will take over six years to pay the balance in full and you’ll pay $825 in interest, which almost doubles the amount you pay back versus the initial purchase(s). This is because a significant portion of your payment is going toward paying off the interest, with the remainder paying down the principal. As you increase the amount you pay monthly, your timeline decreases.

Getting back to the budget you’ve created - having all income/expenses laid out in one document makes it’s easier to determine where you are spending unnecessarily. What expenses can you eliminate to have an additional $75 to put toward this credit card so that you can pay it in full in just one year instead of six? As an example, going out to dinner one time less per week might be one way to eliminate five years of credit card payments and save you over $600.

There are online debt calculatorOpens in New Windows that can help you figure out the timeline for paying off your debt. You input the balance, APR, and monthly payment for each loan, then the calculator will determine the total amount of time it will take you to pay off all your debt.

Use the Snowball Method for Quick Payoff

The snowball method of debt repayment means you start by paying more toward the debt account with the smallest balance, while continuing to make the minimum payments on all other accounts. Once the balance on the first debt account is paid in full, you add the amount you were paying on that account to the minimum payment on the next account (the one with the second smallest balance) until that one is paid off. Continue this strategy until all your debt balances are paid.

This method is a relatively quick way to pay off balances one by one, and helps you to see progress in a short period of time.

Use the Avalanche Method for Big Payoff

Using a different strategy, the avalanche method involves, you starting with your account that has the highest interest rate. Like the example in the table above, you then try to pay double or triple the minimum payment on that account, while making minimum payments on all other accounts. Once that account is paid in full, reallocate that same payment amount to the next account on your list with the second-highest APR.

The avalanche method allows you to first eliminate debt that costs you the most in interest. Ideally, you want to be paying as little in interest as possible on the money you borrow, but some types of loans/credit are simply more expensive to secure. The avalanche method is the best way to make a large dent in the overall cost of your debt so that more of your payments will go to your actual principal balances (instead of interest).

Both the snowball method and the avalanche method implement a similar technique with slightly different goals. The one that’s right for you depends on your personality type and what’s going to keep you motivated to keep paying off debt as quickly as you can.

Modify Your Budget As You Pay Off Debt

Revisiting your budget (and making any necessary adjustments) at least once a month is a good practice. When you’re actively working on reducing your debt, you will start to feel a sense of accomplishment to pay off an account, and will motivate you to tackle to the next obligation on your list. The process is empowering - you will start to see that with planning, discipline, and a little bit of sacrifice, you can take control of your finances.

Learn More About Budgeting at Lafayette Federal

Lafayette Federal Credit Union offers tools and resources to support the financial well-being of its members. We work with our members to provide the education they need to succeed - whether it’s for credit building, homebuying, fraud prevention, and more.

Not a Lafayette Federal member yet? You can become a member by completing an online membership applicationOpens in New Window.

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