What is the best way to avoid falling into debt? A guide

If you’re like most Americans, you have big life goals you’d like to achieve — like owning a home, sending your kids to college, or retiring early. You may assume taking on debt is necessary to achieve these goals — however, that’s not always true. In most cases, you can avoid unnecessary debt entirely and approach good debt strategically to live a life free of financial constraints. 

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In this blog, we’ll discuss how to avoid debt and financial habits that can help you maintain debt-free living. 

What is the best way to avoid falling into debt? 

Establishing healthy, long-term money habits is the key to avoiding debt. Take a closer look at the best strategies below.

Create a monthly budget — and stick to it

The pressure to take on debt grows when you regularly buy things you can’t afford, don’t plan for larger purchases, or don’t save enough for unexpected expenses. The best way to avoid these pitfalls is to create a budget. 

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Creating a budget you can stick to helps you track and manage your cash flow, plan for the unexpected, and allocate money according to your needs and wants. Here are four budgeting strategies worth exploring.

• Zero-based budgeting: A strict budgeting tactic where you track every dollar you spend on paper, in a spreadsheet, or on an app. 
• 50/30/20 rule: A flexible budgeting strategy that allocates 50% of your monthly income towards needs, 30% towards leisure, and 20% towards savings and debt repayment.
• Envelope system: An old-fashioned budgeting method where you withdraw your paycheck in cash and separate it into envelopes. Each envelope is labeled with a different spending category, such as utility bills, groceries, entertainment, etc. 
• Pay yourself first: A proactive approach to budgeting in which you set up automatic transfers to your savings account after each paycheck. The amount that remains in your checking is used for discretionary spending.

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The key to sticking to a budget is choosing one that comes easily to you. It’s also important to review your budget at least once a month to take note of what’s working and what’s not. 

Build an emergency fund

Another way to safeguard your finances is to create a healthy emergency fund that can cover unexpected expenses as they arise. When you don’t have money to cover car repairs, medical bills, or emergency travel, it can be tempting to turn to credit cards or take out a personal loan. 

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Instead, an emergency fund will act as your cash reserve, providing you with a safety net that you can tap into as needed. Start by saving $1,000, then work toward saving three to six months of your living expenses.

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Establishing emergency savings is especially important for people who don’t have a steady paycheck and experience income volatility, such as gig workers, seasonal workers, and the self-employed.

Be flexible with your spending habits 

As you create and achieve different financial goals — or experience fluctuating income — you’ll need to adjust your spending habits. Sometimes, living within your means makes sense, such as when you’ve cashed out on a good investment or landed a higher-paying job.

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However, if you’re at a point in your life where you are saving up for a car, paying off student debt, or working towards a raise, you may want to live below your means for some time. Frugal living helps you reach large financial milestones faster than if you were to maintain your regular spending habits. It also allows you to prioritize what is truly important to you and creates room for better financial opportunities in the future.

Avoid lifestyle inflation

You may think of debt as something that happens only when you’re at a financial disadvantage. However, you can fall into debt just as easily when making good money. As you earn more, be careful not to give in to lifestyle inflation. 

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Lifestyle inflation, also known as lifestyle creep, is when your expenses and obligations rise disproportionately after your income increases. While there’s nothing wrong with splurging a little more, sometimes excessive spending limits your ability to save, invest, or even cover basic expenses. When this happens, you can end up in a worse financial situation or jeopardize your future financial security.

Plan large purchases in advance

Preparing for large purchases ahead of time can also curb the need for debt. Most people need to take out a loan to purchase a car, a home, or start a business. However, by incorporating these needs into your budget, you can reduce the debt you incur. Planning in advance also gives you the opportunity to leverage various strategies to boost your cash flow—e.g., investing, opening a high-yield savings account, or taking on an extra job to boost your income. 

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Scheduling automatic transfers into a high-yield savings account after every paycheck is one of the best ways to save for a large down payment. Whether you’re saving up for a starter home, investment property, or your dream car, automating deposits into a high-yield savings account will help you get there a lot faster. 

Save strategically for major life milestones

Many Americans are concerned that their social security benefits won’t be enough to sustain them in their later years. According to the Social Security Administration, social security benefits may not be paid in full and on time after 2037. As a result, saving up for retirement has become increasingly important. 

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The same is true for college tuition. In the last 20 years, the average cost of college tuition in the U.S. has grown about 56%. Here are two savings plans to explore if you’re interested in saving specifically for retirement or a college education. 

• Roth IRAs allow individuals to make tax-free withdrawals and choose where their contributions are invested. Roth IRAs make sense for individuals who want to diversify their taxes or anticipate higher tax rates in retirement. 
• 529 savings plans allow families to save for a child’s future education while enjoying state tax benefits. Although scholarships and grants provide some long-term assistance, the price of education is consistently rising. It’s best to save money for your child’s education so they can choose freely among community colleges, state institutions, or out-of-state universities.

Pay off your credit card balance in full

One of the easiest ways to fall into debt is to overuse your credit card. High utilization can negatively impact your credit score and also make it harder to pay off your balance. 

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Be sure to pay off your credit card bill in full before your payment cycle ends. This helps you keep your spending under control, avoids expensive interest, and can keep you debt-free. 

Only borrow when you have a plan

One way to protect yourself from accumulating unnecessary debt is to only borrow when you’re sure you’ll be able to pay it back. As much as you may want to buy a house next year, it may be best to wait until you increase your income, improve your credit score, or wait out a hot housing market.

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You should also try to minimize the amount you need to borrow by saving up for a large downpayment. This reduces the principal amount, total interest charges, and the time it takes to pay off the loan. It’s also important to assess how debt fits into your short—and long-term financial plans. 

Keep track of your assets 

Lastly, consider how you can leverage your assets to finance large purchases. Instead of taking out unsecured loans with high interest rates and less favorable terms, consider tapping some of your assets to access cash.

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A few assets to always consider (with due caution) are: 

Roth IRAs

Roth IRA contributions can be withdrawn at any time without penalty, however, taking funds out of your Roth IRA means missing out on valuable, untaxed growth and should only ever be done as a last resort. Additionally, Roth IRA earnings can be withdrawn penalty-free through the Homebuyer’s Exception. Aspiring homeowners can take out up to $10,000 in earnings from their Roth IRAs for a first-time home purchase as long their account has been active for at least five years.

401ks

If you have a 401k and experience extreme financial need due to tuition payments, medical expenses, or threats of foreclosure, you might qualify for a hardship withdrawal. The IRS has specific criteria regarding 401 (k) hardship withdrawals, but it can be a lifeline that helps you avoid debt or losing your home. It’s generally not recommended to tap into your retirement savings, so make sure you’re exploring all other possible avenues first. 

Home Equity

Homeowners can tap into their equity to finance just about anything. There are several equity financing tools available: 

• Home equity loans: A home equity loan provides a lump sum of cash upfront, which you pay back over 5-30 years. Borrowers usually start making fixed monthly payments immediately after receiving the funds. 
• Home equity lines of credit (HELOC) A home equity line of credit (HELOC) provides a revolving line of credit you can borrow from for up to 10 years. Borrowers begin to pay back a HELOC after the withdrawal period is over. The repayment period lasts 10-20 years and has fluctuating monthly payments.
• Home equity investment (HEI): A home equity investment gives you access to a lump sum of cash in exchange for your home’s future appreciation. There are no monthly payments. Instead, you repay your investment any time during a flexible 30-year term.

Final thoughts on avoiding debt

As you can see from the strategies mentioned above, there are several ways to avoid taking on debt. Creating a budgeting system that works for you, establishing a healthy emergency fund, and practicing mindful spending are all proactive ways to minimize the allure of debt products. 

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However, most people will need to engage with debt at some point, so it’s important to know how to manage debt effectively. Paying off your credit card balances in full, borrowing only the necessary amounts, and leveraging assets to finance large purchases are some ways to be strategic about debt accumulation and management.

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