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Debt has the potential to work against your financial health, but it doesn't have to be the enemy. If you take on debt for a worthwhile purpose, and if paying it off fits well within your budget, debt can help you grow strong financial habits, strengthen your credit and achieve your goals.
There are situations where debt is best to be avoided, however. For example, credit card debt you can only afford to pay the minimum toward each month can lead to sky-high interest charges and lower credit scores. Another example is a car loan with a monthly payment that stretches your budget uncomfortably. That can put you at risk of falling behind on payments and affect your ability to cover other important bills.
These six tips can help you stay on the right side of debt, which means taking it on only when it's necessary and affordable, and when it will benefit you.
1. Build an Emergency Fund
It sounds paradoxical, but saving in an emergency fund is a key component in avoiding debt. Experts recommend saving three to six months' worth of essential expenses—more if your work is seasonal, freelance or unpredictable—to provide a savings cushion if you lose your job.
Another use for an emergency fund is to cover unexpected expenses that would otherwise go on a credit card. If your car needs urgent repairs or you need dental work, for instance, pay for it with your emergency fund if you're able (and replenish that money as soon as possible). That way, you're not suddenly on track to credit card debt that could end up taking years to pay off.
2. Choose a Spending Plan
Overwhelming credit card debt can also sneak up on you if you're regularly making purchases you can't pay off at the end of each month. The best way to avoid overspending is to make a plan for each dollar you earn.
A budget can be as general or as detailed as you want it to be. It can mean dividing your spending into needs, wants and short- and long-term financial goals with the 50/30/20 plan or using one account for fixed expenses and another for discretionary spending with the two-account plan. A zero-based budget assigns a purpose to every dollar so you know exactly where your money is going. No matter which strategy you use, you'll get into the habit of tracking expenses and making sure you're spending less than you earn.
3. Stick to a Savings Routine
Automating your savings strategy makes it easier to build a solid emergency fund, and to set aside money for other goals like retirement. Plus, when you separate that money from your checking account, you're less likely to spend it and potentially go into debt.
Set up automatic transfers each month to your emergency fund, retirement fund—if you don't contribute directly from your paycheck to a workplace 401(k)—and college savings fund such as a 529 plan. The right amount to save depends on your particular circumstances, but if you use the 50/30/20 budget as a guideline, aim to send about 20% of your after-tax income to savings and debt repayment.
4. Pay Your Full Credit Card Bill Each Month
Credit cards may seem like an invitation to buy big-ticket items that you can't immediately afford, since you have the flexibility to pay down the balance over time. That can be useful if, say, you suddenly need to make a major home repair and you're not comfortable using your entire emergency fund.
In general, one of the best ways to avoid debt is to look at your credit card like a debit card: Only buy items you know you'll have enough money in your checking account to cover by the time your bill is due. You'll never pay interest and your credit utilization will stay low, potentially strengthening your credit score. But most importantly, you won't rack up debt that may be difficult to get rid of.
5. Only Borrow What You Need
When you seek other types of credit, like a car loan, mortgage, student loan or personal loan, opt for the smallest loan possible that will help you meet your goals. Making a sizable down payment on a car or mortgage can also lower your ongoing monthly payment.
Student loans in particular should be considered a last resort to pay for college only after you've exhausted federal, state and school grants; private scholarships; and work-study funds. Fill out the Free Application for Federal Student Aid (FAFSA) for access to federal and state grants and low-cost federal student loans.
6. Keep Your Credit Score Strong
Debt may be impossible to avoid if you'd like to buy a house, go to college or buy a car. But you can limit your monthly payments and get a lower interest rate with a good credit score. The higher your score, the more likely it is that a lender will not only accept your application, but that you'll get the best terms possible, saving you money.
Many core debt-avoidance practices also have the potential to improve your credit score. Keeping debt balances low, paying all bills on time and limiting the amount of new credit you apply for are all key ways to build good credit.
The Power of Keeping Debt in Check
Avoiding debt doesn't have to mean paying for everything in cash. It's possible to make use of financial products that can get you rewards and grow your credit, yet still stay out of debt. Stick to your spending plan and pay off monthly credit card balances in full, and you'll have taken the first and potentially most important steps toward lasting debt freedom.
With a free Experian account, you can monitor your credit report, which includes the last-reported balance on your credit accounts, to better understand your debt.