When does a person actually consider themselves in debt? For example, my husband and I purchase items on our credit card every month and then pay that balance off in full at the end of the month. Would you consider that debt? In theory, that’s a short-term loan that is being paid off approximately 30 days later, which meets the financial definition of debt. We don’t consider that debt, though, because we make sure that we have budgeted enough money to cover the balance at the end of the month, but someone could make the case for that short-term borrowing as debt. While we may not consider this debt, this got me thinking about the different ways people can manage debt. Here are 3 ways to successfully manage and reduce your debt.
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Get Organized
You can start off by making a list of all the debt you currently have outstanding. This would include things like car loans, student loans, mortgages, credit card balances that carry over every month (i.e. not paid in full at month end), drawn HELOC’s, etc. The list can go on for a long time, but the point is to lay out all of your debt on a spreadsheet so you know what you are working with. Don’t just put the current balance either, you will want to know the interest rate that you are paying on each, the maturity or due date for each type of debt and the monthly interest and principal payments.
Once you have them all down, order the debt by the highest to lowest interest rate. More often than not, it will end up being credit card debt first, student loan debt second, followed by car loans, mortgages, etc. The highest interest-bearing debt is where you want to focus your attention. The reason for this is simple, if you are carrying balances on high interest rate debt, that debt balance will grow over time as the high interest rate is multiplied by the rising debt balance, effectively compounding your interest expense every month.
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A Plan Beats No Plan
This line is from Timothy Geithner’s book “Stress Test, Reflections on a Financial Crises” (good read if you haven’t heard of it). A key step to managing one’s debt, whether it be $5,000 or $500,000, is developing a plan. A plan will focus your attention on the debt that is most important. Oftentimes people try to pay off everything at once and realize quickly that they can’t, so rather than come up with a budget and a plan to reduce their debt, they just make the minimum payments on everything. There is nothing wrong with making minimum payments on outstanding debt; however, it won’t get you any closer to being debt free that way and it may even put you in more debt.
A good plan will work hand-in-hand with your budget. If you know how much you spend each month on living expenses and the like and how much expendable income you have each month, coming up with your plan will be pretty easy.
For example, let’s say after all your monthly expenses (rent, food, gas, minimum debt payments on outstanding debt, retirement contribution, etc.) you have $300 dollars left over. Before having a plan you may have spent that on a night out with friends, a new pair of jeans you want, or a new TV for football season. With a plan focused on getting of high interest debt, that $300 dollars is your golden ticket, or at least a piece of the golden ticket. At the end of the month you should take your remaining expendable income and apply it to the highest interest rate debt to reduce the outstanding balance. You can then take the highest interest rate debt balance and divide it by the $300 and see how many months it would take to get rid of that debt (i.e. $10,000 outstanding divided by $300 amount of expendable income applied to that balance = 34 months (33.3 rounded up).
While that seems like a long time, if you get raises and your income increases, you can apply the extra expendable income to the outstanding balance which will reduce the time it takes to pay down that debt. This simple plan can be used to pay down each debt you have on the list working top down, from highest interest rate debt to lowest.
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Don’t Be Afraid to Ask
This sounds crazy, but sometimes you can lower or reduce your debt just by asking! Most people don’t even think to call and ask about reducing their interest rate or restructuring their monthly payments to a lower amount. Creditors are more likely to negotiate the terms of debts that are charged off (dismissed) by the creditor or in collections already.
Additionally, think about moving some of your credit card debts to new accounts with lower interest rates. Moving a balance to a credit card with a 0% introductory rate for 6-12 months can save a lot on interest.
Another option is to ask your bank what the interest rate is on a personal loan or home equity loan or line of credit. If the rate is lower than your higher interest rate debt it may make sense to consolidate your debt by taking out a personal loan or home equity loan and paying off outstanding higher interest rate debt.
