How to Manage Debt in an Economic Downturn
Have you thought about managing debt in the recent economic crisis? You're among many. This 3-part series explores:
- The good, the bad, and the ugly - types of debt
- A “normal” economic downturn?
- Saving money by minimizing high-interest debt
PART 1: Kick ‘em when they’re down... (your credit card and personal loan debt, that is.)
Clearly, the COVID-19 pandemic has impacted our economy greatly. Businesses have been shuttered, unemployment rates have soared, and the Fed has dropped rates to historic lows. But there are signs of hope - reopening and restarting, and an opportunity to better your finances.
In regards to debt, the guiding principle you may have heard time and time again: “Savings is good, and debt is bad.” But as we all know, debt is a necessity in today’s world. Whether you’re paying for a home, college, or a car - debt likely is helping you meet your needs daily.
Economic downturn or not, the key is to manage debt correctly and ultimately use it in your favor. High-interest debt in the form of credit cards and personal loans can be costly. According to ValuePenguin, the average APR for credit cards is 17.4% and the average APR for personal loans is 14.5%.8
Many Americans are inclined to leverage credit cards to pay for immediate expenses. Then when those bills pile up, some end up paying off credit card debt with personal loans, only to find that they are still paying a fairly steep interest rate tacked onto a growing balance. Here are some tips to getting rid of high-interest debt.
- Eliminate credit card debt first. If you do use your credit cards, make sure your balance can be fully paid off within the same billing cycle to avoid unnecessary interest charges and help protect your credit score.
- Next, get rid of personal loans. It’s especially important to pay off variable rate loans first as fluctuating interest rates can significantly increase the cost of your loan.
- Avoid taking on new credit card or personal loan debt.
PART 2: Recessions are normal.
While many things still seem uncertain, there is some good news. Recessions are a normal part of the economic cycle. To put this in perspective, since World War II, we've gone an average of about five years between recessions. The last recession ended over 10 years ago. All things considered, we were overdue.
If you’re cognizant of your finances, and understand how to leverage debt, you can be better prepared in the case of an extended economic downturn. A good rule of thumb is:
- 50% of income goes to necessities (like your housing, food, clothing, medical expenses and other essentials)
- 30% of income can go towards entertainment, travel, and more enjoyable needs
- 20% of income should be put towards your savings, investing, and/or paying off debt
The most important takeaway is that your total spending should be less than your total income each month. Be sure you’re setting aside money for retirement and emergency needs.
Don’t ignore the debt. It’s easy to assume you’ve minimized costs on dining out, entertainment, and transportation, but it’s still crucial to be aware of how much you spend. Some helpful tips include:
- Look for easy areas to cut, starting with mindless spending.
- Make a list of “necessities” versus “wants” on a monthly basis to orient your spending habits in the right direction.
- Know the costs of recurring subscriptions that can add up and renew automatically.
- With Amazon and other online retailers offering one-click ordering and stored credit card information, you should keep an eye out for these purchases specifically.
PART 3: Hindsight is 20/20.
The hope is that we learn from our mistakes. The money you pay in interest can’t be reclaimed. Thankfully, you don’t need to pay it in the first place if you play your cards right.
If you’re carrying a balance right now, you can chip away at debt even if you’ve accrued thousands of dollars across multiple cards and loans. Here are some strategies you can use to protect yourself and even save the money you would be paying in interest for credit cards or personal loans.
- Address the Problem - Note patterns that led you into debt in the first place. Think about how you can manage it better going forward.
- Change the Behavior - It’s never too late to change. Avoid credit card balances and ensure you can pay what you charge each month to prevent racking up debt.
- Set a Budget - Self-imposed constraints can help you avoid harmful spending patterns. Regardless of the economic situation, making a budget is your best bet for saving in the long run.
- Work with a Financial Planner - A professional opinion on your finances can help. If you don’t have access to this option, confiding in a friend or family member for advice can help you regain control.
- Use Home Equity - If you have home equity and are employed, you are in luck. Instead of paying high interest rates, you can quickly reduce debt and save money from the get-go.
Homeowners have an advantage.
Homeowners with equity can benefit from historically low interest rates. A cash-out refinance and home equity line of credit (HELOC) are both good options depending on your situation.
A HELOC is a type of loan that uses your home as collateral in exchange for a line of credit. HELOCs are a great option for financing essentials or paying off higher-cost debt, and can be tax-deductible* if you plan to use the funds for home improvement (whereas credit card interest is not.) Figure’s HELOC provides the entire loan amount upfront at a low fixed rate, and you can continue drawing on the credit line as you repay what you borrow. The average APR on a Figure Home Equity Line is 8.97% as of June 2020.7
In general, HELOC rates are lower than many other types of consumer debt and you can access funds quickly.6 Figure can offer access to your equity in as little as 5 days3 and the application is all online and can be done in 5 minutes.
A Cash-Out Refinance is an alternative way to use your home equity, offering access to a lower mortgage interest rate and cash you need all at the same time.4 The best time to refinance is when you're seeing the Fed lower interest rates. Simply compare the interest rate you're paying on your current loan versus current interest rates, and you'll know when it's time to refinance. Maintain a good credit score to qualify for the best rates. If you want to take advantage of historically low interest rates, Figure offers a 100% online application you can complete in minutes. Figure’s Cash-Out refinance average APR is 3.44% as of June 2020.7
If you don’t own a home (and subsequently don’t have home equity), here are two tactics to help you tackle your debt in the economic downturn.
- In the avalanche method, you would look at your highest interest debt (ex: credit cards) and pay it all off. Then, pay off your next highest interest loan, and so on. This allows you to chip away at larger numbers for longer in the beginning, but over time, you could save more money.
- With the snowball approach, you’ll pay down the smallest value debts first. While you may end up paying slightly more over the long term by prioritizing based on amount, rather than interest rate. It’s very rewarding to rack up a lot of small wins before targeting larger loans.
2 For the Figure Home Equity Line, APRs start at 3.49% for the most qualified applicants and are higher for other applicants. For example, for a borrower with a CLTV of 45% and a credit score of 800, a five-year Figure Home Equity Line with an initial draw amount of $50,000 would have a fixed annual percentage rate (APR) of 3.49% and a 4.99% origination fee. The total loan amount would be $52,495. You will be responsible for an origination fee of up to 4.99% of your initial draw, depending on the state in which your property is located and your credit profile. Your actual rate will depend on many factors such as your credit, combined loan to value ratio, loan term, and occupancy status. The advertised rate of 3.49% APR includes a combined discount of 0.75% for opting into a Quorum Membership (0.50%) and enrolling in autopay (0.25%). APRs start at 4.24% for customers that do not opt in to autopay or apply to become a Quorum member. APRs for home equity lines of credit do not include costs other than interest. Property insurance is required as a condition of the loan and flood insurance may be required if your property is located in a flood zone.
3 For the Figure Home Equity Line, five business day funding timeline assumes closing the loan with our remote online notary. Funding timelines may be longer for loans secured by properties located in counties that do not permit recording of e-signatures or that otherwise require an in-person closing.
6 You must pledge your home as collateral, and you could lose your home if you fail to repay.
7 Average APR on Figure Home Equity Line for 2020 as of June 2, 2020. Average APR on Figure Mortgage Refinance from October 1, 2019 to June 3, 2020.
8 Average APR on credit cards for all card types per ValuePenguin by LendingTree. Average APR on personal loans for an average credit score of 695 per ValuePenguin by LendingTree.