Is becoming debt free the highest priority you have on your financial to do list? It is for one of our new subscribers who asked if I could write a post about what options they should consider.
As we all know, having significant debt service payments each month can be suffocating. I have written in my books and prior posts about different options people can follow to cut debt and related costs. In this post, I will revisit these options and summarize them for those of you who are working to reduce your debt loads.
The Importance of Making Timely Repayments
Timely repayment of debt is central to your financial health. Principal repayments and interest impact your:
Monthly cash flow
Your credit scores
Your ability to qualify for certain types of insurance
Access to future credit
Ability to affordably acquire the things you need including education, health matters, housing and transportation.
Overall, the worse your credit profile and scores are, the more you will pay for borrowing and the worse your terms will be. Being paralyzed by debt related payments also causes huge household stress and anxiety.
As you look at your personal situation, the bad news is that there is no single best way to improve your debt situation. The good news is that you have a number of options you can select to navigate reducing your debt load. Let’s look at the key available options. Using one or several in tandem can help you accomplish your goals.
Option 1 – Increase Monthly Debt Reduction Payments
The first step to accelerate repayment of debt is to increase the amount of money available for debt service. Remember the Federal Reserve has reported that the average interest rate paid on credit card debt is around 16%. In a zero interest rate world, you just can’t pay these rates. It’s really simple, if you’re only making credit card minimum monthly payments each month, you’re barely reducing the principal owed. If you spend less money paying interest, debt gets paid down more quickly. Finding cash to repay debt faster is key to your success.
Option 2 – Adopt a Zero-Based Budget to Identify Excess Cash
Zero-based budgeting (ZBB) is a budget method where your income minus your expenses equals zero (You can see my complete post on this subject by revisiting Moneysavers Post 111. With a zero-based budget, you have to make sure your monthly expenses match your income during the month. You do that by tracking every dollar — down to ground zero — to determine if it is necessary and supports your life goals. By doing this you can identify cash that can be diverted to pay down debt.
Let’s take a look at a hypothetical example of Devin, age 37, who earns $4,000 after-taxes each month. For Devin, he needs to examine his money habits to make sure everything he spends saves, donates, reduces debt or invests for his future adds up to $4,000. This way he will not fall into the situation of spending more than he earns each month. Using ZBB he will know exactly where and on what his cash is used for.
Option 3 – Adopt the Avalanche Repayment Method
From a pure calculation standpoint, you can get out of debt faster — if you target the outstanding balances with the highest interest rate to repay first. You will hear this approach referred to as the “avalanche method.” This saves money by paying off the costliest debt.
Option 4 – Use the ‘Snowball’ Strategy
The Snowball strategy is another approach. It is based on paying off the accounts with the smallest balances first, usually revolving credit card debt, while paying the minimum payment on larger debts. Once the smallest debt is paid off, a person then proceeds to the next slightly larger small debt above that, so on and so forth, gradually proceeding to the larger ones last. You can learn how to implement this method in Moneysavers Post 12. The Snowball strategy works based on positive reinforcement human psychology; by paying the smaller debts first, the individual, couple or household sees fewer bills coming in as more individual debts are paid off, thus providing ongoing positive feedback on their journey towards eliminating their debt.
Option 5 – Balance Transfer Debt to a Lower or No Interest Credit Card
If you have a good credit score, one tactic that can speed up the debt repayment process is applying for a balance transfer credit card. Look for a 0% introductory interest rate period of at least 12 months. Since transfer fees can be as high as 3 to 5%, do some comparison shopping on websites such as Creditcards.com, particularly if you’re looking to transfer a large amount of money.
A balance transfer is simply the process of moving debt from a high-interest credit card to a new card with a lower interest rate, ideally one with an introductory 0% period. Essentially, you're using one card to pay off another, but because you aren't paying as much in interest, you have more money available to pay down your debt more quickly. A balance transfer makes financial sense only if the money you save on interest is more than any fee you'll pay to carry out the transfer. Many credit card or debt management websites have calculators that can assist you with determining the savings you will create with the transfer.
Option 6 – Apply for a Debt Consolidation Loan
If you don’t want to use the option to transfer your debt balances onto a credit card, or if you have debts like a car loan or student loans that will take years to pay off, another debt repayment option is a debt consolidation loan.
This essentially is an unsecured personal loan, although some financial services providers do market loans specifically for debt consolidation. If you’re struggling to become debt-free because you’re saddled with high rate credit card interest, this option can give you some breathing room. These loans generally come with fixed rates which can be several percentage points lower than credit card interest rates.
Option 7 – Consolidating Payments with a Debt Settlement Company
Another potential but more serious option for debt consolidation are plans offered by debt settlement companies. With these programs, the debt settlement company may be able to secure lower monthly payments with your creditors by negotiating a reduced balance on your accounts. You then make one "consolidated" payment to the debt settlement company each month, and in turn the company makes payments to each of your creditors on your behalf.
Once an account is included in this type of program, the creditor will close the account. Closing your credit cards will cause your credit utilization rate to increase, which can hurt credit scores. The creditor may also add a statement to the account that indicates the payments are being managed by a debt consolidation company. This statement may be viewed negatively by lenders who manually review your report.
Programs like this may lower your monthly bills, but because you are not re-paying the full amount owed on your accounts, your creditors will likely report those accounts as "settled" or "settled in full for less than the full balance." Because it indicates that you did not pay the account as agreed, a status of settled on your credit report will impact your credit scores negatively, even if there are no late payments on the account.
Even though the debt consolidation company will be making payments on your behalf, you will still be responsible for ensuring those payments are made to your creditors on time. If the debt consolidation company fails to make a payment on time, the late payment will be reflected on your credit report.
Before entering into any debt consolidation plan, research the offer to make sure that the company is reputable and that you fully understand the terms and implications of the program.
Option 8 – Renegotiating the Terms of Your Debts
You know the saying, if you don’t ask for something in life, you won’t get it. So if you don’t want to use any of the options discussed above, try calling up your credit card issuers and debt holders and ask each for a lower interest rate. If you’re current with your payments and have a reasonable credit profile they may say yes or at worst you will be no worse off. You may find that the lenders knock a few percentage points off your interest rate, which will lower the cost of servicing your debt.
Summary
When it comes to debt reduction, you have options. The key is to select and diligently follow through on the option(s) you select to manage your debts. As I have written, debt is not necessarily your enemy and if used properly can enable you to improve your economic circumstances and financial security. The key is to make an objective decision about the debt before taking on new obligations. If you can develop this habit you will save thousands your entire life.
If you're looking for ideas on where to find cash savings, please buy my new book, The FinancialVerse Guide to Savings – 600 Cash Savings Ideas. Cash Savings provides practical suggestions for where you should look for savings as part of your day-to-day life. For most households, I believe they will find at least $600 in annual savings.