In this article, we'll learn about debt and credit, and look at strategies to use it efficiently.

Debt

Debt, in general, indicates something that we've borrowed and thus owe it back to the lender.

First of all, why do we need to get into debt? It allows us to borrow money to pay for something we need right now, with the understanding that we'll pay back the debt (possibly over time) to the lender. The simplest example is to buy a house. Say we're planning to start a family and decide that it would be a good idea to buy a house instead of paying rent. Our own house would give us much more freedom to change things as our family grows. Instead of waiting for our wealth to grow enough to buy a house, We borrow money to buy a house, so that we can continue to enjoy the house while paying off the loan.

Credit

Credit is simply our capacity to borrow. It is a measure of to what extent a lender can trust us to repay a loan. It depends both on our financial worth (if we are wealthy, there is a good chance we'll repay the loan), and our record of having repaid loans in the past. From a lender's perspective, if we've defaulted on loans in the past (even though we were wealthy), there is a chance we might default again.

Our credit score is a standard way of indicating our credit worthiness. A high score tells a lender that, if they lend money to us, they can be reasonably confident to get it back in the specified time. Too many loans, or too many instances when we couldn't pay the entire required amount, all reduce our credit scores. At the same time, not having any debt also affects our credit scores, since absence of any debt makes it difficult to really know how credit-worthy we potentially are. Once again, a good financial advisor can identify strategies to increase and maintain a good credit score.

Debt Reduction

Debt reduction goes hand in hand with saving. This is especially important when carrying high-interest loans where the interest payments can, over time, become a big portion of our monthly expenses. The sooner we reduce our debts the faster we're on the path towards financial independence. In this article we'll explore a few ways to do that.

The majority of us carry some debt throughout our adult lives. Borrowing money allows us to undertake big projects (education, buying a car or home, etc.) that we otherwise won't be able to. But, incurring debt is also based on the assumption that our income will grow soon to let us repay the loan in a reasonable time. Sometimes, life creates events that delays our ability to do so. It may even force us to create more debt. And, since most loans charge an interest on the unpaid debt, debts could quickly snowball out of control.

It is thus very important to take control of our debts and ensure that we're borrowing only what we really need to. When we have multiple loans, it is a good exercise to create a plan to pay them off and become debt-free. Too much debt can also adverse our ability to borrow money in future.

Strategies

There are multiple strategies to reduce our debts. What all of them have in common is to accelerate our payments, and to order the payments efficiently to eliminate our debts quickly. Let's see some of them:

• Focus on reducing the total amount of debt quickly: with this strategy, after ensuring that we've paid off the minimum required amount for all the loans, we start paying off the loan with the highest debt. If we have any money left over, we pay off the next highest debt. And so on. This is the fastest way to pay off all the debts.
• Focus on reducing the number of loans: here, we pay off the loan with the smallest debt first (after making the minimum payments towards all loans). Even though this method may take longer to pay off all the loans, the number of loans will reduce faster. As loans with smaller amount will get paid off quicker, seeing loans disappear provides a psychological boost.
• Focus on reducing the interest that the loans generate: this strategy targets loans with the highest interest rate first (after making the minimum payments towards all loans). It prevents the interest amounts from becoming huge, and if they're already big, it helps in reducing them first.

Note that there are other strategies to reduce debts: for example, consolidating multiple (typically high interest) loans into a few (typically low interest) loans and then paying off the new (low interest) loans quickly, Similarly, different types of debts may have different effects on our credit scores. Thus, there are strategies that focus on maintaining certain loans to ensure a good credit score. These techniques are beyond the scope of this article as they are all very specific to each person's situation. Your financial and/or tax advisor that understands your particular financial needs is the right person to discuss these with.

Tax Issues

Certain loans (e.g., home mortgage loans) allow the interest payments to be tax-deductible. Therefore, not paying off such loans may actually reduce our taxes just a wee bit. The pros and cons of this needs to be studied and understood well for each individual's case before deciding to either pay off such loans or to hold on to them.

Summary

We saw a few ways of how to reduce our debts. As there can be different kinds of debts for different purposes, there are also several ways to reduce, consolidate and eliminate them. A good debt reduction plan tells us how long it'll take to get there and how much resources we need.

Each time we eliminate some debt, we get a boost and tells us we're moving in the right direction towards taking control of our finances and achieving financial independence.