The economic impact of debt is determined by two factors: the cost of debt and its use.
If consumers have borrowed money at low interest rates to buy appreciating assets, that is generally considered “good debt.” Unfortunately, American debt is looking increasingly “bad” this year.
The vast majority of U.S. household debt is housing related. Housing debt accounts for 72% of the total debt balance as of the first half of 2022.
And mortgage rates have climbed significantly in recent months, which means this form of debt is even more expensive. Average 30-year mortgage rates have hit 5.5% — up from 3.22% at the start of the year. Meanwhile, some economists expect housing prices to slump in the years ahead.
Household debt is a leading indicator of recessions. And the fact that households may have to pay more for a depreciating asset is likely to be a drag on the economy.
Consumers must tackle this issue to protect themselves from an economic shock.
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There are two methods to mitigate debt. Borrowers can implement a long-term repayment plan that systematically reduces their debt burden over time. Or they may consolidate their debt to lower its cost and make it easier to manage.
For most borrowers, a combination of both these methods could be the best approach. Here’s a closer look at how these strategies work.
Debt repayment plan
A debt repayment plan could help consumers gradually reduce their debt burden. Borrowers either pay their largest balance (the snowball method) or highest interest rate (avalanche method) loans first while making just minimum payments on all other loans.
Once the biggest or most expensive loan is paid off fully, they can move to the next loan and repeat the process.
This strategy should help borrowers steadily chip away at their total debt burden over time. And these plans work best if the borrower is patient, disciplined and strategic. However, it could take weeks or months to see tangible results.
For quicker relief, debt consolidation is an ideal strategy. The method involves combining different types of loans under one loan agreement.
For instance, a borrower with multiple credit cards, auto loans and personal loans could work with a financial adviser to combine the total outstanding balance under a single loan. This method could reduce the borrower’s total interest expense.
It also makes the debt burden easier to manage and repay over time.
This simple method is often highly effective. A study by consumer credit reporting agency TransUnion found that debt consolidators were able to successfully reduce their bank card debt by 60% over time.
Additionally, 70% of debt consolidators saw on average an immediate 20-point boost to their credit score. These consumers also perform financially better than non-consolidators after one year of applying this method.
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