Freedom From Debt

Of course, the title of this post is an exaggeration on both sides. Credit cards are neither a friend nor a foe.  They are a merely a tool, and how you use them (or abuse them) is what will determine whether they help you or hinder you in your progress to becoming debt free.

A credit card can be used for the sake of convenience, for online shopping and the dozen other uses for which it was designed, none of which are necessarily a bad thing.  For others, a credit card can become a means of increasing revolving debt to unmanageable levels, requiring the borrower to pay obscene amounts of unnecessary interest every month.

Many who let credit card debt get out of control see debt consolidation as the way out. They are often presented with a stack of offers to reduce their credit card debt by consolidating all their debt onto one card.

But those offers, though they frequently tout ‘lower interest rates’ should be viewed with a skeptical eye. Those lower interest rates are usually only available to a select few with very good credit ratings. That doesn’t apply to the typical person who is struggling to overcome a history of excessive debt and find a way out.

But, they can offer a way to solve the problem over the long term. You may, in fact, be able to qualify - the only way to be sure is to apply. But even if you’re accepted, there are several key items to keep in mind when considering this solution.  If your credit is in very bad shape and you suspect it will be unlikely that you’ll be approved, you may want to not even apply as excessive inquiries into your credit report via loan applications can actually harm your credit score.

Very rarely will such credit card offers lower the actual amount of principal outstanding.  As a result, you have exactly the same amount of debt on the day you acquire the new card and, over the long term, you will actually sometimes pay more.

A lower interest rate can obviously be a benefit, but lowering the rate doesn’t always mean lowering the total amount you’ll have to pay to relieve the debt.  If you pay 8% on a debt of $10,000 for, say, five years you will pay more than paying 10% on $10,000 for two years.

The reason for this is the compounding effect of interest. The total amount of interest paid in the first case is $2165.60. The net interest rate overall is 21.656% when calculated as the percentage paid beyond the principal. In the second case, you pay only $1074.80, with a net interest rate of 10.748%.

Remember the 8% vs 10% are the APR in each scenario. APR means the annual percentage rate, this is the rate for a one year period, not the total percentage of interest.

Of course, the upside is that in the case of 8% over five years, you pay only $202.76 per month, in the second case you pay $461.45 per month. Many will find the former payment easier to manage than the latter. And, you may be able to find some middle ground. Calculators available online will help you run through the different scenarios, in order to guide you to choosing the one that’s best for you.  Assuming you have no prepayment penalty (unlikely on a credit card), if you have some discipline you can get the 8% card and just pay the extra money towards the principle every month.  Minimum payments are not your friend, regardless of the interest rate on your card, you’ll need to pay more than the minimum each month to make significant progress toward relieving your debts. 

If discipline is not your specialty, considering a consolidation loan with fixed payments over a pre-determined time table may be a better way to resolve your debt.  Several online lenders offer fairly competitive rates these days and, as long as you make your payments when due and stop taking on additional debt, you will have an exact date that you will be debt free.

I just got the new issue of SmartMoney in the mail and its got a great article called “Live Debt-Free” in it.  It has tips on debt consolidation, improving your FICO score, different types of debt, playing the 0% interest juggling game, etc.

Unfortunately, the article isn’t available on their website, but its worth picking up a copy off the magazine at the store if you want a nice, comprehensive article on managing your financial debts and building a plan to becoming debt free.

I just built an Amazon Store for this blog, you can check out the magazine section here.  SmartMoney is only $12 per year or $18 for two years…its a bargain.

The blogosphere and financial periodicals have been all a twitter lately about the subprime meltdown, tightening of loan standards and skyrocketing rate of foreclosures.  Many who were able to get into a home over the last several years despite their less than perfect credit feel that because they got a mortgage already, that they have little to worry about with the current debacle.  Unfortunately, that may not be the case.

The concern I have is for those who financed using ARMs (adjustable rate mortgage) in the last few years to take advantage of a lower rate but are planning on refinancing to transition into a more long term loan once their ARMs unlock.

The headlines I’ve been reading are that the lenders are really tightening up their loan standards.  That means that if you go to refinance your loan and don’t have a significant amount of equity in the property already, its likely that you’ll have a more difficult time finding a lender who will loan to you if your initial loan was considered ’subprime’ (due to lack of documentation on income, poor credit, etc). 

When analyzing their financing options or debt handling issues, many people neglect to include the tax implications of one strategy over another. While calculating and including the tax implications in your scenarios can become very complicated, the benefit from doing so can clarify which decision is most beneficial to your own situation. The level of complexity in these calculations is also reduced greatly by the plethora of computer programs that are available to help you. Even without a computer, there are a few simple guidelines to keep in mind.

In the U.S., the biggest tax write-off for many individuals is the interest paid on a property loan. Since they represent large debts paid over many years, the interest is the overwhelming majority of the total monthly payment, at least for the first several years. As a result, much of that interest paid can offset taxable income and make a real difference in the amount you have to pay when April comes around.

But there are other tax issues involved with other forms of debt that should be factored into planning. Home equity debt is only one option, even without a home you have other loan options besides using your high interest credit cards.

Taking out a home equity loan used to be primarily for the purpose of making improvements to the property. Many people these days use that money for a much wider variety of goals. A HELOC (Home Equity Line of Credit) can be used to finance just about anything - an auto purchase, repayment of credit card debt, you name it. Once you have the HELOC, the money is mostly yours to do with as you wish.

One advantage of this home equity type of debt is precisely the tax benefit. Just as with a primary loan, interest on a second mortgage or a HELOC is tax deductible. So, even when the interest rate is the same as a credit card (and they are often much lower), the net result can be beneficial as you’ll be able to write off the interest on your taxes.

The only way to know for sure in your circumstances is to do the calculations. Online loan calculators are readily available that will help you do just that. Run through several scenarios to decide the effect in your case. Your income, debt-to-equity ratio, credit scores, etc will all impact the potential benefit you’ll get from using home equity loans versus other types of debt.

It is possible to obtain a loan to pay for large medical costs. Some people pay for such things with a credit card, which is possibly the most expensive way to finance the debt. Sometimes that’s necessary, no one size fits all recommendation is possible, but you should carefully research your options before paying for any large expenses with credit card debt.

Since much of the interest on medical loans, and sometimes the medical expenses themselves, is tax deductible it can be worthwhile to finance the costs that way.

Interest on or amount paid to student loans, too, is tax deductible up to a point. Your circumstances will vary, again, based on income, years out of school, amount of debt, etc. Tax filing software is probably your best bet for calculating the pros and cons in your individual case. As you answer the ‘interview questions’ you can put in the amounts and follow the tutorial to determine the impact. Feel free to even use last years edition of the software if you have it, it’ll likely be close enough to give you a ball park estimate of the benefit of one approach over another.

Regardless of the specific situation, whenever you are considering assuming debt, especially for large amounts, taking the time to evaluate the tax implications can save you substantial amounts of money. The amount you save can easily be worth a couple of extra hours of research, especially since you’ll be able to use that knowledge time and time again. Checking out a basic “Taxes for Dummies” book from your local library or purchasing a basic how-to book off Amazon.com can serve as a lasting resource for considering the tax implications of various types of debt. If you find that you are unable to find software or resources to do the basic calculations that you need and you don’t have the time to read up on the subject on your own, try contacting a certified public accountant to see how much they would charge for a basic consultation. They’ll often offer you free advice or a reduced rate, with the hope of you using them in the future for additional help.

It might seem that developing a budget should be a basic task for any working person, but many people are simply not comfortable using spreadsheets, balancing their checkbooks or creating a formal budget. Some folks aren’t disciplined enough, others don’t consider themselves “number people” and find the thought of putting a budget together daunting.

Regardless of the excuses not to do it, everyone will find it in their best interest to make the effort to outline their expenses and income even if it requires getting some help from someone else. A basic budget needs to include monthly income and expenses, projections of increases and decreases in those amounts and a little buffer for the unexpected.

If you feel uncomfortable using spreadsheet software, just write your basic income and expenses out on a piece of paper. If you are open to using a spreadsheet (which will make it a lot easier to track and tweak things), many options are available for free these days such as Open Office (http://www.openoffice.org/) or Google’s online spreadsheet (http://docs.google.com/).

To assemble the basic budget, divide the spreadsheet or page into two columns. In the first column, list income that you have (benefits, interest, paycheck, etc). In the second column, write down all your monthly expenses (costs) including all of your regular bills, typical grocery costs, gasoline, etc. I’ve found the easiest way to find out these numbers is to look at the last few months of your bank statement and try to break up most of the expenses into categories that you can track on your budget. You don’t have to be exact, but lean to the conservative side if given a choice. After you’re all done with the income and expense columns, add another 10% for unexpected expenses.

Now that you have created your basic budget, you can start to reap the benefits. You have the basic numbers, now you can tweak them to project different scenarios. Make another hypothetical budget that shows monthly income and expenses, just like before, except this time project what it would be like if you could eliminate some of your ‘luxury debt’.

On your hypothetical budget, exclude monthly credit card payments, take out your monthly auto loan payments and eliminate 25% of any ‘impulse buy’ amounts that you found while you were categorizing your expenses from your bank statements. After your done, sum the total of these three numbers.

These three numbers represent the amount you could conceivably avoid paying every month. If the total is even 10% of your monthly expenses (and for some it’s higher), you are paying a substantial amount of your income to charges that could be avoided.

No one but you can decide whether that 10% overhead you pay is worth what you get in return. Your desire to have items before you can pay for them outright is weighing you down with debt. Every dollar you owe someone else is a dollar less that you can spend how you’d like on things that you would really appreciate (be it saving for the future, buying a treat for yourself, or saving up for a more significant cost that you see in the future).

As you debate your options, consider this, saving that 10% APR paid on $2,000 for one year is $110.00. Many people pay only the minimum monthly payment, which amounts to much more. That’s $110 you are paying just to have $2,000 dollars worth of stuff a year earlier. Also, look at how much of that $2,000 worth of stuff is still around. Did you buy long lasting items that really better your life or did you spend most of that at restaurants on dinners, on clothes you’ll likely not wear next year, or on gadgets that you forgot about long ago.

Only you can decide which is worth more to you, having something early or freeing yourself from debt, but developing a budget will help you make those decisions rationally and seeing it all on paper will often help people really see where their money is going.

Turning up the heat

As you can imagine, there are multiple approaches to reducing your debt levels, some less painful than others.  The obvious and most widely used approach is to just pay the minimum on all your cards and a little extra here or there as your budget allows.  While this approach can eventually succeed, it can take a very long time before you see significant progress and it takes great determination to keep up with the somewhat Laissez-faire approach without any structure, clear strategy, timeline, etc.   For those with large debt levels, using a unstructured approach to tackling your debts can leave you with a hopeless feeling. 

This article is all about one debt reduction approach.  It may not work for everyone, but its simple, effective and very structured.  The approach we’ll cover in this article is called the “snowball method” (so named by Dave Ramsey).

The technique

The technique is, in essence, very simple. Order your debts from lowest to highest. Pay the minimum required on all monthly debts, then allocate any remaining funds you can to paying off the smallest debt. Thus, the smallest debt will get paid off first. This frees up yet more money to apply to the next-smallest debt. Repeat until you have reached the level you want.

The snowball method has several advantages.  By “snowballing” your debt payments, you’ll see regular, visible progress in reducing your debts and, in a relatively short period of time, you could well be down to a livable level. As you roll-off those debts, you have more free income which can be split between payments on the debt next in line and the enjoyment of some of the rewards of having less debt (more disposable income, more money available to put towards retirement, less stress, etc).

Psychology is king when it comes to reducing your debt

Psychologically,  the snowball approach helps keep the debtor motivated to continue the program. Seeing real progress helps one stick with it during a financially challenging period. 

One can get carried away with attacking high-interest loans first which is, technically, a better approach in the long run for in regards to total interest paid but the psychological benefit of the snowball approach should not be underrated.   Seeing your number of outstanding loans decrease month over month or year over year will keep you going.  You’ll see tangible results.  Snowballing the debt payments will also help to keep you disciplined as you’ll know exactly how much you should be paying every month toward eliminating your debts.

Don’t be distracted by credit card “rewards”

By rigourously adhering to the snowball approach, you’ll know how much you should be paying each month and won’t fall victim to credit card trickery.  Keep in mind credit card companies don’t really want you to pay off your debt.  If you pay it off, they’ll make no interest off you.  As you start to decrease your debt levels, don’t be surprised if your credit card offers you a lower minimum payment on a given card or a ‘payment-free’ month.  Its their attempt to keep you paying interest.  When they make you this offer on the snowball approach, you can either ignore it entirely or, if that card isn’t your card with the lowest balance, you can apply that month’s payment to your current snowball target. 

Once you’ve started attacking your debt, consistency and determination are key.  You need to stay motivated and get positive reinforcement to continue your debt reduction cycle.  The snowball approach to reducing your debt offers you strategy, rigidity, and a very rewarding system to start reducing your debt levels immediately, starting with this month’s payments!

Get the facts

The first step to handling any problem, and excessive debt is no exception, is to focus on facts. In regards to managing your debt, focusing on the facts means finding out how much debt you really have, what kinds of debt you have and what the monthly payments and interest costs are on your debt.  This post is the third article in my series about debt.  The first article introduces you to your credit report and the second goes into detail on the FICO score that you will get back when you request your credit report.  Armed with your credit report and FICO score, you’ll be able to have the pieces to put together a ‘debt inventory’ of the accounts you have open, balances you are carrying, minimum payments on each account and, with a little extra work, the interest rates you are paying on each account.  Doing the work to find out the interest rates on your various accounts is optional in taking your ‘debt inventory’, but will allow you to more easily prioritize which accounts you should pay off first.You may be surprised how many people are troubled by debt problems, but haven’t done the work to calculate how much monthly interest they’re paying to service their debt.  Part of the problem may be that they really don’t want to know and, considering how much it sometimes is, one can hardly blame them.

Research your interest rates

Fears and denial aside, the first step back to financial health is a good diagnosis.  Call your creditors, check your latest statements online, or dig up your most recent paper copy of your credit/loan statements to determine the interest rates on your various accounts.  If you’re paying $200 per month in interest charges alone on a monthly net income, say, of $4,000, then you are paying 5% per month of your income for essentially nothing.  It’s not entirely nothing, since you are enjoying the things you bought early (instead of saving and purchasing with cash), but you should be honest with yourself and question whether being able to make those purchases early is worth 5% of your income.

When that $200 a month becomes the total you can pay each month, you have reached a point where you will never pay off the debt.  If all the money is going to interest, none is going to principal.  Some sources say paying the minimum payment on credit cards often takes around 8 years to eventually pay off the balance…thats IF your credit card company even requires you to pay any principal every month, some don’t.  Take a look at a past statement and consider how much of the monthly payment goes toward interest versus repayment of principal.

Suppose it’s 90% interest, 10% principal. That’s approximately the case for the average home loan for the first several years. You can use an online calculator to see how long that will take in your situation.

Suppose, for example, you owe $10,000 at 7%.  You could pay only $116 per month, but it would take you 10 years to pay it off.  The interest would cost you $3,933 - almost 40% of the total amount.

Debt Repayment Techniques

Now that you’ve seen your situation, you need to take two further steps. Develop a budget that will allow you to make payments as large as you can handle to get the bills paid off.  If you have several accounts, you could use the ’snowball method’ (I’ll post a future article on the details of this approach) and pay off the smallest one first. Then apply what you were paying to the smallest to the next smallest (now the smallest), until you’ve reached the end.  This ’snowball approach’ quickly builds up your payments each month and will allow you to start to tackle even some of the largest debts in your ‘debt inventory’.  If you only have one loan or credit card, fancy debt repayment techniques aren’t necessary, just pay off as much of the debt as you can afford each month.  Make it hurt if you need to, you’ll be glad you did in the end when you are debt free!

The alternative to the snowball approach is to just take on your largest debt first. That would save you the most in dollar for dollar interest each month (though other accounts may have higher interest rates), but it’s hard for many people to stick to this approach when they see such slow progress.  Start simple, snowball to kill off your smallest debts first.  You’ll see progress, build discipline, and rapidly start to build up your snowball to tackle your larger balances.

Stop Taking On New Debt

Now, for the hardest - and most important - step of your debt management process (which should be carried out simultaneously with the first)…stop borrowing. You should not allow yourself to incur any further debt until you have gotten your existing debt under control.  That ‘reasonable level’ varies on your types of debt and your own will power.  Make sure to make steady payments so you can see progress.  Making progress will boost your desire to further control your debt levels and having the desire to do it will motivate you much more than any article or book will ever do.

Facing reality and making a commitment to long-term change are the two hardest things for anyone who has entered financially turbulent waters to do, but honesty about your situation and a plan for controlling it are critical if you want to recover your financial health and independence.