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Do You Have to Take on Debt? Here’s How to Do it The Right Way

Here's what to know before you're stuck in a hole you can't dig yourself out of.

Joy Velasco for Fatherly

At some point or other, a lot of folks have fallen into what feels like a financial Twilight Zone. The furnace goes bust or the car needs a new transmission – or your employer unceremoniously hands you a pink slip. Suddenly, there’s not enough cash in your bank account just to scrape by. You have to take on debt. But what’s the best way to do so? Is there a best way to take on debt?

Most of us aren’t excited about the idea of going into the red to make ends meet, but it happens. The only real mistake is taking out credit without a game plan, which too often leads to long-term debt that becomes an emotional albatross. Should you need to take on debt, here are five pointers to make sure that you come out in one piece.

1. Ask: Why Am I Taking on Debt?

This seems like a simple question, right? But it’s crucial to ask. Because you never, ever want to sign up for credit unless it’s for something you need, not something you merely want.

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The reality is that most of us are pretty good at blurring the lines – and that’s what can get someone into a world of hurt. The average American household carried a revolving credit card debt of $6,124 last year, according to a NerdWallet survey. Sometimes, that’s because of an unforeseen crisis, when there simply isn’t another way to pay the bills. But often, we’re ringing up those charges to pay for new TVs or trendy jeans.

Unless you’re in dire need or using the funds as an investment – say, you’re starting up a bakery or going back to college – you’re probably better off avoiding debt.

2. Get Your Credit Report into Shape

There are any number of ways to handle a cash crunch, whether it’s with a credit card, a personal loan or a home equity line of credit (HELOC). One thing each of these has in common: lenders are going to pull up a credit score to figure out how likely you are to pay them back.

A 3-digit number may seem like a pretty crude way to judge your credit risk, but for lenders who process millions of loans, it’s a crucial time (and money) saver. The higher your score, the more competitive your interest rate is likely to be.

Credit-scoring firms like FICO use data from your credit reports, so pulling out a copy of each – TransUnion, Experian, and Equifax all have a file on you – is something you’ll want to do well before you apply for a loan (you can get a free copy at AnnualCreditReport.com). Make sure to dispute any errors that might be dragging down your score.

The reality is, any big improvement in your FICO are likely to take time. The two biggest factors are the size of your current balances and the timeliness of your payments. So if you’ve used credit responsibly in the past, you’ll find it easier to borrow again at favorable terms.

3. Find Low-Cost Ways to Borrow

In general, you’re going to get lower interest rates on secured loans – that is, those where you’re putting up collateral. For homeowner’s that makes home equity loans and lines of credit among the least expensive sources of cash.

Some banks are now offering home equity loans at less than 5 percent for their most well-qualified borrowers, something that was once unheard of. That’s not to say borrowing against your home isn’t without downsides. You’ll probably have to fork over closing costs before borrowing against your home, which typically run 2 to 5 percent of your loan value, and there’s always a temptation to use credit lines like an ATM. But those rates are pretty enticing, for those who meet the requirements.

Among unsecured forms of credit, personal loans tend to offer some of the most attractive rates. In today’s low-interest rate environment, those with higher credit scores can sometimes snag loans with less than 7 percent APR, according to Bankrate. Plus, you pay them back with monthly installments – usually in one to seven years – which makes your expenses predictable.

When you compare those interest rates to what credit cards tack onto your revolving balance, you’ll see why plastic can be so insidious. Even borrowers with the most enviable FICO scores usually see a rate or at least 14 percent these days, and it can go considerably higher for regular Joes. What’s more, card companies are remarkably good at keeping you under their ball and chain. For larger balances, monthly minimum payments are often around 3 percent or less of the amount you carry over. That may sound awesome in the short run, but it guarantees that you’ll remain in debt unless you’re disciplined enough to pay more. Many people aren’t.

Of course, getting your hands on a little extra dough doesn’t always require going through the banking industry – there’s always mom and dad, or a well-heeled college pal. Unless your family is struggling or tight-fisted, it might be the cheapest way to borrow, at least on paper.

Whether the emotional strain of being in your friend or family’s debt is worth it is a separate – and crucial – question. For a lot of adults, this is an absolute last resort scenario. Should you have to come groveling to your loved ones, making the deal as transparent as possible can head off unpleasant holiday get-togethers down the road. A basic document detailing how much you owe, the interest rate (if they’re charging you) and when you’ll pay it back can do wonders.

4. Have a Plan to Get Debt-Free Again.

Even before the coronavirus torpedoed the job market, a lot of Americans were already living in credit hell. In a LendingTree survey from December of last year, for instance, 60 percent of respondents said they were weighed down by debt.

How do you avoid that trap? Having a plan certainly helps. It’s easy to get so wrapped up in the financial mess in front of you to look at the long-term ramifications of a new loan or credit line, but they’re real.

Obviously, creating a budget – one that includes your new loan payments – is a huge part of getting the debt monkey off your back. Will you able to pay your installments with your current income, or do you need a temporary side-hustle? Are there other areas where you can trim back, like a pricy cable TV package or regular carryout meals?

Getting rid of credit card debt presents its own challenges. Because minimum payments are so low, you’ll want to create a target amount that allows you to wipe out your balance in, say, 12 or 24 months. Whatever you do, don’t keep relying on your card, even after you got past your temporary rut. Hide it if you have to. Throw it in the fireplace. Just don’t keep adding to your tab.

5. Take Advantage of COVID Relief Programs

If you’re one of the millions of Americans who have been financially impacted by COVID, you may have access to deferment programs that will prevent your credit from tanking during the pandemic.

Discover and PNC, for example, are both offering temporary relief for qualifying borrowers. And HSBC is deferring loan repayments for up to 180 days through its hardship program, after which customers can pay the deferred amount in a lump sum or accept an extended repayment schedule.

Regardless of your job status, another bill that you may not have to worry about right now is your federally-owned student loan. That’s because the Trump administration extended the loan deferment program to December 31, enabling borrowers to skip payments until the new year.

By minimizing your existing loan payments as much as possible, you may not have to borrow as much to get through these insane times. In any case, however, the key is to be proactive and reach out to your lender before you miss payments or take out new credit that you may not need.