Managing your debt
Credit cards are especially tempting. It's not just that the debt that has to be paid back, the finance charges keep coming in every month, as well. Credit card finance charges can easily exceed the cost of normal monthly expenses like telephone costs or even home heating, which makes you wonder where your priorities are. In many cases, people get into trouble with credit cards and consumer debt because they do not track their debt situation and they do not know what the cost of carrying that debt is. How do you get your finances back in order?
First, inventory your debt, including consumer debt, credit card debt and long term debt such as a mortgage or student loans. Here is what you need to know for each debt:
- Current Balance
- Interest Rate
- Minimum Payment
- Finance Charge Expenses (monthly estimate)
Use a spreadsheet to inventory your debt. Mortgages and other long term debt are the easiest to deal with. You can assume that the payments will be the same each month until paid off. The only consideration is whether you wish to pay off the debt earlier, how much additional amount should you pay toward the principal each month? Because long term debt tends to have lower interest rate charges, it is often better to pay the minimum payment. Inflation helps the debtor, and the closer your interest rate is to the rate of inflation, the lower your actual finance cost for this type of debt. You may have a long term plan to pay off the house before you retire, so it may be wise to pay a little additional each month to achieve your time plan and pay off the home early on your schedule.
Other debt, such as home equity loans, car loans, and credit card debt needs to be reviewed based on the interest rate and finance charges. Low interest debt can be used responsibly. High interest debt is almost always a mistake. The other side of responsible use of credit is that you need to be sure that you are purchasing something you need and which will give you a long service life. Of course, you also have to be relatively secure about the income source that will pay off the credit.
If you have a number of high interest debts, there is the possibility of consolidating the higher interest debts into a lower interest rate loan, with the goal of reducing the finance costs and the minimum payment. Watch the loan costs when refinancing, it may be a good solution if the costs are reasonable.
Some would encourage you to use cash for most or all purchases. This is a good idea, although it is difficult when trying to repay existing debt. As you pay off your debt, you can work toward prioritizing major purchases and saving money to make strategic purchases using savings rather than credit.
An example of responsible use of debt, if you do not have adequate savings, is an emergency roof repair paid for with a low interest home equity loan. This is a responsible way to take care of a repair that must be completed. The repair preserves and adds to the value of the home and there could be a loss if the repair were not carried out immediately. Purchasing a reliable, efficient vehicle at a good price to replace an unreliable vehicle is also a responsible way to use credit, if the interest rate and other charges are reasonable. What is a reasonable interest rate for credit?
Generally, credit with an annual interest rate of about 2 to 4 percent above the rate of inflation is reasonably priced and can be used for purchasing items that will give you a long service life.
When starting out on your financial plan, you may not have the resources to pay cash for things you need. Eventually your goal should be to eliminate debt, however in reality, you may not be able to avoid debt. Just be aware that there is good debt and bad debt, and try to plan a way to get out of debt completely.
Funds from your income for paying off debt are in competition with other needs and goals, such as saving for strategic purchases, investment and building up an emergency fund. The first step in debt elimination is to set up automatic, minimum payments to all of your debt finance institutions. This guarantees that you will not pay any late fee penalties.
OK, you have automatic payments set up to pay the minimum payment for each of your debts. But minimum payments are not enough to get you out of debt quickly. You must also dedicate extra funds to pay off debts early. So how do you apportion the extra funds between the various debts that you have?
Pay off the highest interest rate debt first.
Focus all of your debt payoff funds to the debt with the highest interest rate. Pay the high interest rate debt to reduce the finance charge and be able to direct more funds toward the principal amount. When you pay off the high interest rate debt, shift your funds to the next highest interest rate debt.
If you have serious debt problems, you may have to direct most of your discretionery income to debt payment. If your debt is low or moderate, and your finance charges are relatively low, you need to balance the priority of paying off debt with the need for investment, strategic purchase, and emergency fund savings. In most cases, you should put at least nominal amounts toward these items, even if you have debt. Start making small payments each month so that when your financial house is in order, it is easy to increase the payment amount.
This strategy means that you will achieve debt payoff in the shortest possible time with the funds you have available. A recommended long term goal is to carry only debt for your home, and to save money in advance for planned strategic purchases to avoid consumer debt.
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