If you continue to add bad debt (consumer debt) by shopping for things you cannot afford such as a new car, new home improvement projects and furniture etc using your credit cards, you will find it very difficult to accomplish your long term financial goals. Consumer debts are different from good debts such as a getting a cheap mortgage loan, since the items purchased do not appreciate in value over time nor earn you any monetary returns. Even so, you can spread your finances too thin if your good debt to income ratio is too high. A prolonged loss of income can also create difficulties in meeting your good debt obligations and monthly payments.
It is more important to get rid of bad consumer debt that is costing you high interest rates. This should come first before your other good debts if they are reaching dangerously high levels. You will not be able to achieve any financial success unless you eliminate bad debts completely. It is important to maintain financial solvency so that you avoid future credit problems.
The best debt reduction method depends on your individual financial situation and whether you have a stable income and current level of savings or assets. Reducing any unnecessary spending will be good for accessing more cash for paying down your credit card debts.
Using Savings to Reduce Your Consumer Debt
Many people have some savings but refuse to use it for paying off their high interest credit card bills or car loans. For example, they have $10,000 holdings in stocks and bonds investments that can be used to completely pay off their consumer debts, but feel that they will miss out on making money in doing so.
You may feel uneasy about ending up with reduced assets and savings, but you also reduce bad debts which are costing you a lot of interest fees the longer you carry them. It is unlikely that your savings and investments are earning returns higher compared to the prevailing consumer debt interest rates, especially for bad credit unsecured loans which can be around 30% or higher. Furthermore, there is no guarantee that you will definitely make positive returns with your investments since the stock or bond market carries a certain level of risk.
Furthermore, your investments may be liable to federal or state tax. Thus, individuals with higher tax brackets will need to seek even more high risk high return investment products in order to justify your decision of not paying off your high-interest consumer debt with funds meant for investments. Note that most investment experts make only an average of 10% returns before taxes, so be realistic with what you expect to gain.
A safer approach is to simply pay down your consumer debts, which instantly guarantees that you save 20% or more on further interest payments. A dollar saved is as good as a dollar earned! Make sure you pay off the loans charging the highest interest rates first, which are probably the unsecured personal loans from instant payday lenders with no credit check.
On the other hand, if you are thinking of paying down credit card debts using your savings, remember to leave enough cash for emergency situations. A good estimate is to have at least enough savings to cover 6 months of expenses for yourself, your family and debt obligations. Some financial planners suggest to use 6 months of income as emergency reserve, which is even better since it assumes you can take up to that period to find a new job. This sum of money will relieve you of any pressure to borrow short term loans in case of any unexpected large expenses that cannot be covered with your insurance or simply temporary job loss.