How to manage debt

Like death and taxes, debt is somewhat inevitable. We all will likely encounter it in some form or another during our adult lives. 

Perhaps it's the credit card bill after an overseas holiday, a car loan, or the HECS loan used to finance university studies. It could be the mortgage on your house or even just a plain old IOU with a friend.

In many cases, debt can be helpful. It means we can afford a roof over our heads or a sweet ride. Or the education required to get our dream jobs.

But debt can also be suffocating.

Homeowners will be familiar with the dread of watching interest rates creep up while wondering how to afford their ever-increasing mortgage repayments. But even those who don't own their own homes will probably still be familiar with the panic of opening an unexpectedly high credit card bill!

If you have high levels of debt, it makes it much harder for you to grow your wealth. More of your money will have to go towards servicing your debt, reducing your capacity to save and invest. In a worst-case scenario, this can force you into a debt spiral, where you must take out even more debt just to cover your existing loan repayments.

When your debt gets out of control like this, it negatively impacts other aspects of your life. Constantly worrying about how you can afford to make your next repayment can cause high levels of stress and anxiety – and it can even put a significant dent in your self-confidence.

But debt doesn't have to be scary.

Putting in place the techniques and strategies to properly manage your debt ensures that you always remain in control of your debts – and they don't end up controlling you!

In this article, we help you understand what debt is – including some of the most common forms of household debt, like credit cards and mortgages. We will also look at some of the steps involved in effective debt management so that you can efficiently deal with your debts (and hopefully even stay debt-free!).

Understanding debt

We can use debt to finance all sorts of things, from everyday retail purchases to homes, cars and education costs. It can be structured in different ways, depending on the type of purchase the debt is intended to finance. For example, a home loan usually has a longer term and a lower interest rate than a short-term personal loan designed to finance a holiday.

Below, we take a closer look at the most common forms of debt people encounter in their daily lives.

Credit cards

Credit cards are one of the most recognisable forms of debt, issued by banks or financial institutions. They allow you to make purchases up to an agreed credit limit and are especially common as society becomes increasingly cashless. Some are even entirely digital, stored on smartphones.

How They Work:
Instead of using cash, you charge purchases to your credit card. At the end of the monthly billing period, the provider requires repayment. You can either:

• Pay the full balance (avoiding interest).
• Make a minimum payment (incurring interest on the remaining amount).

In exchange for this line of credit, issuers charge interest—often at higher rates than other types of loans—along with possible annual fees.

Benefits of Credit Cards:

• Convenience: Accepted almost everywhere, including online.
• Rewards: Some offer cashback, frequent flyer miles, or other perks.

Risks of Credit Cards:

• High Interest Rates: Carrying a balance can lead to expensive debt.
• Potential Debt Trap: Easy access to credit can encourage overspending.

While credit cards can be useful—especially when paid off in full each month—they can also be a costly form of debt if not managed carefully.

Car loans

A car loan is a personal loan used to buy a new or second-hand vehicle, typically repaid over one to seven years. This is one of the most common types of debt, and it can be either secured or unsecured.

Types of Car Loans

• Secured Loans (most common)
  • The car itself serves as collateral.
  • If you default, the lender can repossess the vehicle.
  • Typically lower interest rates and higher borrowing limits.

• Unsecured Loans
  • No collateral required, but less common.
  • Higher interest rates and stricter borrowing limits.
  • Often used for cheaper second-hand cars.

Key Features to Consider

• Balloon Payments: Some loans reduce monthly repayments but require a large lump sum at the end, which still accrues interest.
• Fixed vs. Variable Interest Rates:
  • Fixed Rate: Monthly repayments stay the same, making budgeting easier.
  • Variable Rate: Repayments fluctuate with market interest rates—potentially lower costs when rates drop, but riskier if they rise.

While car loans offer a structured way to finance a vehicle, it's important to compare inte

Mortgages

For most people, buying a home is the largest financial commitment they'll ever make. Mortgages—home loans used to finance property purchases—make up the majority of household debt. The property itself serves as collateral, meaning the lender can repossess it if payments aren't made.

How Mortgages Work

• Instead of paying the full purchase price upfront, you provide a deposit (typically 20% of the home's value) and borrow the rest from a bank or financial institution.
• Some lenders accept deposits as low as 10%, but this often comes with higher interest rates and Lenders Mortgage Insurance (LMI) to protect against default risks.
• Mortgages are long-term loans, typically repaid over 20 to 30 years, covering both:
  • Principal (the amount borrowed)
  • Interest (the cost of borrowing)

Key Mortgage Features

• Interest-Only Periods: Some loans allow borrowers to pay only the interest for a set period, reducing initial repayments but increasing long-term costs.
• Fixed vs. Variable Interest Rates:
  • Fixed-Rate: Locks in a set interest rate (usually up to five years), offering predictability.
  • Variable-Rate: Fluctuates with market interest rates, which can lower or increase repayments.
• Refinancing: Once the fixed-rate period ends, the mortgage typically shifts to a variable rate. Borrowers can refinance to secure better terms.

While mortgages provide a path to homeownership, it's important to compare rates, loan terms, and repayment structures to ensure long-term affordability.

The real cost of debt

Here at the Fool, we bang on a lot about the magic of compound interest. It can be a fantastic way to grow your wealth over time, making you far richer in retirement. 

Essentially, 'compound interest' means you earn interest on your interest, so the longer you leave your wealth to compound over time, the greater the returns you can earn.

But the dark side to compound interest is that it also applies to your debts. As you accrue interest on your debts, these too attract interest, quickly increasing both the repayments on your debt and the amounts you owe. This is how you can find yourself in a debt spiral, where your debt increases beyond what you can afford to pay – a pretty scary prospect!

The real cost of debt eats away at your wealth potential. When an ever-increasing amount of the money you earn is going towards repaying your debts, it means you cannot save and invest. 

So, not only does your debt increase, but you also miss out on the potential compound returns you could otherwise earn if you saved your money instead of giving it straight to your creditors. So, your debt actually hurts you twice over!

Steps for effective debt management

You can effectively manage your debts in many ways – some of which may be unique to your circumstances. 

If you encounter serious debt issues, it's always best to speak to a professional – like a financial advisor or financial counsellor – who can work with you to tailor a financial plan that best suits your needs.

However, here are some broad steps to follow in a successful debt management plan:

1.      Assess your debt

The first thing to do is be honest about how much debt you owe. This can often be a sobering prospect, but it's a vital step in dealing with your debt once and for all. 

Be sure to include all your debts – including your mortgage, credit cards, car loans, HECS-HELP debts and any other loans you are responsible for.

It's also a good idea to include the interest rates charged on each of these and how much the monthly repayments are. This can help you in your next step… prioritising repayments.

2.      Prioritise repayments

Not all debts are equal—some charge higher interest rates (like credit cards), while others are long-term and stable (like fixed-rate mortgages). Paying off certain debts before others can be both financially and psychologically beneficial. Here are some methods for prioritising debt:

Snowball Method (Motivation Boost)

1. Pay off smallest debt first while making minimum payments on larger debts.
2. Once a debt is paid off, roll that payment into the next smallest debt.
3. Repeat until all debts are gone—your repayments grow like a snowball.

Pros: Quick wins keep you motivated.
✘ Cons: May cost more in interest over time.

Avalanche Method (Saves More Money)

1. Pay off highest-interest debt first while making minimum payments on others.
2. Once that debt is gone, move to the next highest interest rate.
3. Repeat, reducing the overall amount spent on interest.

Pros: Saves the most money long-term.
✘ Cons: Progress may feel slower if high-interest debts are large.

Debt Consolidation Option

If you have multiple debts (e.g., several credit cards), you might consider debt consolidation:

• Take out one loan to pay off all debts.
• Instead of juggling multiple interest rates, you now have one repayment to manage.

Pros: Simplifies budgeting, potentially lowers interest.
✘ Cons: If the new loan has a higher rate or longer term, you could pay more over time. Always check for hidden fees before consolidating.

Prioritising debt wisely helps save money, reduce stress, and improve financial stability. Choose a method that fits your situation and keeps you motivated!

3.      Create a repayment plan

Once you've assessed your debt levels and come up with a method to prioritise your repayments, it's time to devise a repayment plan. In this step, you should calculate how much of your income you can devote to paying off your debts.

The best way to do this is to create a weekly or monthly budget. Compare your total income with all your regular expenses, like rent, groceries, utilities, transport costs and spending on things like clothing and going out. Be honest with yourself about your spending. Otherwise, you won't be able to develop an accurate budget.

Once you've estimated your total costs, see if there are things you can cut back on (at least in the short term). Continue until you get to the point where you maximise the amount by which your income exceeds your costs. This difference is the money you can put towards paying off your debts.

The more money you can afford to devote to your debt repayments, the faster you can repay your debts – but you should still be honest (and realistic) about what you can cut back on. Otherwise, you're only setting yourself up for failure.

You should speak to a financial counsellor if you cannot reach a point where your income exceeds your costs. The National Debt Helpline is a great resource and provides free financial counselling – the number is 1-800-007-007.²

4.      Negotiate with creditors

This step is so important that our Chief Investment Officer here at the Fool, Scott Phillips, even came up with a hashtag for it a few years ago: #getabetterrate. 

He encouraged everyday Aussies to share their stories about how they 'spring cleaned' their finances and reduced the interest repayments on their loans – simply by contacting their creditors and negotiating a lower rate.

A vital step in any debt management plan is understanding the interest rates being charged on your loans (particularly your mortgage). 

If you're getting a bad rate, see if you can negotiate a better one, or even switch to another lender. And if this sounds a bit daunting or complicated, financial counsellors can assist you with this process.

Understanding Debt-to-Income (DTI) Ratio

The Debt-to-Income (DTI) ratio is a key metric in debt management that compares your monthly debt payments to your gross monthly income. It helps lenders assess your ability to manage additional debt and is a useful tool for evaluating your financial health.

How to Calculate DTI

For example, if you have $2,000 in monthly debt payments and earn $5,000 before taxes, your DTI would be 40%.

Why DTI Matters

• A lower DTI (below 36%) indicates better financial stability and borrowing capacity.
• A higher DTI (above 43%) may signal financial strain and make it harder to secure loans.

Reducing your DTI—by paying off debt or increasing income—can improve financial flexibility and boost your creditworthiness.

Avoiding future debt

Setting up an emergency fund to cover any unforeseen expenses (or a loss of income), as well as separate accounts to save up for things like holidays or other large personal purchases can be a great way to ensure you don't go into further debt. 

If you get in the habit of saving up for your purchases, you won't need to rely as much on loans, especially credit cards, to help finance the lifestyle you want.

And if you do use a credit card for everyday purchases, try to make sure you pay off the full balance each month, to stop your interest payments getting out of control.

Although it might not feel like it at the time, the best financial decision you can make is to pay for your purchases using money from your own savings rather than taking out more debt. Be honest with yourself about what you can afford within your budget – but set up separate savings accounts so that you can still splurge on luxuries every now and then.

Foolish takeaway

Oftentimes, taking out debt can be the only realistic way we can afford large purchases. Very few people have the cash available to buy their own cars, homes or education outright.

But taking on too much debt can be dangerous – especially if it is very expensive, like credit cards or short-term personal loans. Not only do you limit your ability to grow your wealth, but in a worst-case scenario, you might even be caught in a debt spiral. 

This can have negative psychological impacts, causing you untold stress and anxiety – and often hurts your self-confidence and sense of financial independence.

The best thing you can do to stay on top of your debts is to set up and regularly review a debt management plan. Continually assess your debts, prioritise repayments, and develop an achievable repayment plan. 

And maximise the benefits when you are debt-free by investing your money or saving it in an emergency fund. This will help you avoid debt in future and give you peace of mind, knowing that you are in control of your debts – and they aren't controlling you!

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This article is part of Motley Fool Australia's comprehensive Investing Education series, covering everything from budgeting and saving to basic investing concepts and how much money you'll need to start.

Packed with easy-to-understand and regularly updated information, our articles contain the answers to your most frequently asked questions about share market investing.

Motley Fool's Education series is tailored for beginner and experienced investors alike and also includes helpful tools and resources, an A-Z glossary of Investing Definitions, and guides to specific topics of interest, including retirement planning, gold and property investment.

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FAQs

Is $20,000 a lot of debt?

Whether $20,000 is a lot of debt depends on factors like income, interest rates, and financial obligations. For someone with a high salary and manageable expenses, it may be manageable, but for someone with a lower income or high-interest loans, it can be a significant burden. The type of debt also matters—student loans or a mortgage with a low interest rate may be more manageable than high-interest credit card debt.

How to pay off $30,000 in credit card debt?

To pay off $30,000 in credit card debt, cut expenses, increase payments, and use the avalanche or snowball method. Consider balance transfers, debt consolidation, or credit counseling for lower interest rates and better repayment options.

What is an unhealthy amount of debt?

An unhealthy amount of debt is one that strains your finances, making it difficult to cover essential expenses or save. If debt-to-income (DTI) exceeds 40%, or if high-interest payments prevent progress toward financial goals, it may be unsustainable.