If you’re thinking of debt, that’s what you’re going to attract.

It is true, if you spent all your time thinking about how much debt you are in, you may feel helpless and lose the fortitude to move forward in relieving yourself of debt.  The irony is, thinking of saving (the opposite of taking on more debt), may be just what you need.

Debt and spending is closely tied to savings, the more you do of one, the less you have left over for the other.  The more savings you have, the less you often need or want to borrow.  Since you’re paying out interest by borrowing, and therefore likely not getting interest by saving, you’re burning your financial fuse on both ends.

When you put money into your IRA, obviously, you are not spending it.  You collect interest on the money saved which will compound over time.  See one of the many online calculators or read about the rule of 72 to get a feel for how compounding can help turn a few thousand dollars into many thousands of dollars over time.  In addition to the interest aspect, in funding your IRA you also get a tax benefit since, by design, any money put into the account represents a tax deduction.

Instead of being taxed on the money you put in now, you are taxed on that money when you begin to use it many years later. The idea being that later in life you will likely be in a much lower tax bracket and therefore will pay a much smaller amount than you would if you pay taxes on it now during your working years.  Here is a link to historical tax rates if you’re curious how our current rates compare to those of the generations before us.  While the logic to sock money away now tax-free to pull it out later as taxable income is good advice for many, it doesn’t make sense for everyone.  Luckily, there are now a plethora of retirement account options available to you.

One variation, for example, is the popular Roth IRA.  You pay taxes on each dollar you put into the account as you would normal income, but federal regulations allow tax-free withdrawals as long as the contributions remain in the account for five years and you are at least 59½.  There are many financial planners these days preaching that you should put a part of your portfolio in pre-tax and part in after-tax retirement accounts so you can balance your tax situation when you start making withdrawls.

For folks who have diffcult with the willpower needed to save, 401k are often a useful tool because the withdrawls are usually just pulled straight out of the earner’s paycheck.

The point of this article isn’t necessarily to offer advice to which type of account is best for you, but to recommend making contributions to some type of retirement account.  If you get your mind off  ‘debt’ and onto ’savings’, your positive mental attitude may have a seriously positive impact on your financial health down the line.

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.

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 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). 

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.

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.

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!

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.

One very important element in your overall credit worthiness package is your FICO score. FICO is just another word for your credit score. With an above average FICO, you have access to plenty of capital at reasonable rates. With an average FICO score you’ll likely be able to get a loan for just about anything you need. With a sub-average FICO, you’re basically at the mercy of any lender that you need to borrow from. We all know this, we know our credit score can be a key to opportunity or a hindrance to financial progress, but what exactly is a FICO score and how does it affect your debt management choices?

What is FICO?

FICO is an acronym formed from the letters of its founder, the Fair Isaac Corporation. Its a score between 400 and 800 that ranks credit worthiness according to a proprietary algorithm invented by the company, Fair Isaac, with 400 being the worst and 800 being the best. Other companies now have their own variations, but the basic calculations are similar and you’ll hear FICO and ‘credit score’ used interchangeably throughout the lending and financing process.

How is it calculated?

Though the details of the algorithms are closely held secrets, many people over the last many years have “reverse engineered” several of the important factors, determining the basic pieces that go into the calculation of your FICO score. Any late payments will lower your score, with the quantity and severity of the lateness variably affecting the score, sometimes heavily. The total amount of debt carried per month is another element. A less important factor is the number of credit cards and credit checks performed. The last note about the number of credit checks performed may cause a double-take but, yes, the number of inquiries into your credit score can affect the score itself. The logic being that the more times you apply for credit (thereby causing inquiries), the more likely it is that you may be in a more precarious financial position. I know, it isn’t always true, but its just another factor that goes into the score. Often times these days, some more common types of credit checks for rental situations, identity verification, etc don’t count against you, but its worth remembering that frequent applications for credit can still hurt your score. Keep this in mind as you work your way out of debt.

What is an average FICO score?

Any score below about 620 is considered marginal and below 580 is considered poor. Scores of 720 and above is very good to excellent. A range between 620 and 720 represents a kind of gray area, where items other than your FICO (work history, income, expenses, etc) will play a more significant role in loan decisions.

Banks, mortgage companies, credit card issuers and other lenders will use your FICO score as a very important factor for deciding whether to make a loan, and at what interest rate. Other things being equal, the higher your score the better interest rate you can obtain. Some institutions won’t even loan to those with less than average credit or, they will loan, but it will be at exorbitant rates.

Of course, many times all other things are not equal. Prevailing interest rates in general, the current demand for loans, the general economy and other factors have a significant impact on the willingness of lenders to lend and at what rate.

The entire lending industry has undergone at least two significant shifts in the last 20 years. With the increasing use of computers and modern financial techniques, underwriting loans is done very differently today than in the past. Not surprisingly, the Internet has shifted finance to a very different mode of working. The days of having to head down to the local bank with your financial statement and begging for them to loan you money are gone. Websites such as E-Loan and Bank Rate will show you the best rates available and you can fill out loan applications easily online.

Even with all these changes, though - or perhaps because of them - the FICO score remains a primary tool for lenders. It may not determine the final decision, but it definitely influences the lender’s ‘ten second’ evaluation when presented with a stack of applications to approve or deny.

Dealing with a bad FICO score

Fortunately for those who have financially slipped, there are alternatives. Though your FICO may be low, you still have several options. The first thing to do is set into motion a plan to improve your score.

As you work to remove those outstanding overdue debts - either through paying them off or negotiating with the lender - your FICO will gradually improve. The age of 30 day past due, 60 day past due (or longer) late payments is a factor in calculating your FICO so you’ll see your score steadily improve over the months as you make payment arrangements and relieve your old debts.

At the same time, you can shop around for lenders willing to take a higher risk by lending you money, there are some very interesting options out there these days for troubled borrowers that simply weren’t around even 5 years ago. Head over to My Two Cents to check out the article on Prosper.com. The downside is those loans almost always carry a higher interest rate. Your best approach is to try to forego borrowing for as long as possible while you work to improve your debt situation. Your FICO will follow suit. If you don’t know your FICO score or how to obtain it, check out my earlier post to find out how to obtain a free credit report and what you can expect when you receive your copy.

The reports contain a multi-year history of your credit cards, home loans and other debt. They also record any late payments that have occurred and how late they were whether it be 30 days, 60 days, etc past due. The reports will list any current and old addresses and often your phone number and social security number.

That information is readily available to any qualified party - a bank, a mortgage lender, a credit card issuing company and certain others during legal proceedings. But, though the companies all genuinely try to maintain accurate records, the reports may contain errors and often contain inaccuracies that may harm your credit rating.

They may list loans as active that have been paid off. They may list current credit cards you canceled long ago. They may fail to list payments made to make up overdue amounts. They may show accounts that you were added onto as a family member that you no longer want to maintain. Often the inaccuracies aren’t due to sloppiness on the part of the credit bureaus but simply a reflection of timing, inaccuracies reported by lending institutions and other common human errors in keeping records. The world may be computerized, but those databases still don’t always communicate effectively between companies using different systems.

The only thing an individual can do about this - out of self-protection, if nothing else - is to get copies from all three agencies and review them thoroughly. Make a note of any errors, establish proof of the error, then send a registered letter with the proof to the agency asking them to correct the data. Often calling the lenders that are reporting the inaccuracies is a good start as they may be able to clear up issues for you or provide proof that the data is inaccurate which will help your effort to clear the instances off of your credit report.

Thanks to recent legislation, you can obtain one free copy of your credit report per year. There are numerous ways to do that by filling out a form online or calling. One way is to go to: annualcreditreport.com.

On a more positive note, having the information at your fingertips allows you to develop a debt-free plan for your future. Understanding your past credit history is the first step in creating that plan.

Review your history and note any current overdue amounts. Clear those up first, as quickly as possible. One method is to pay off any smaller outstanding amounts first. That frees up funds to be used on the next larger outstanding amount. Working your way up, you will eventually begin to see light at the end of the tunnel. This concept of compounding your payments to pay off debt quickly will be discussed in a future post on this blog…stay tuned!