Uncommon Cents

In our series on basics, we’ve looked at cash flow, the wealth equation, and baseline budgeting; this time we’ll look at debt reduction.

With saving, it’s clear that even if you don’t do anything else, as long as you put money away regularly, you’ll likely do reasonably well with your money. With debt payoff, it’s much more insidious. If you have serious amounts of debt (or even if you don’t but you want to make efficient use of your dollars when paying off debt), you need a plan. Where to start?

~ Assessment: When considering debt reduction, it’s important to consider all of your debt, and if not all facets, the most important ones. Who do you owe? How much? What kind of debt is it (mortgage, student loan, credit cards, auto loan)? What’s the interest rate? Is the interest tax deductible? What’s the minimum due every month? You may also want to consider any special circumstances, like if the interest rate is variable and may change soon.

Once you’ve determined all of these, you may want to add up your monthly obligations to see how much you owe every month at the minimum. If it scares you, then it scares me too.

~ Planning: All of your debts require the minimum payment; you will likely want to concentrate on one of your debts at a time. How to choose? The Debt Snowball, made famous by Dave Ramsey, suggests paying the minimum on all of your debts except for one: the one with the smallest total. Put all of the money you can toward reducing your smallest total debt, ignoring interest rates, and when that is paid off, switch your efforts to the next smallest total debt. While this flies in the face of mathematics, many have used the Debt Snowball effectively. It seems to me that the primary advantage of the Debt Snowball is psychological–there’s a sense of accomplishment in seeing one debt shrink every month, sometimes dramatically, and eventually paying it off, which would happen relatively quickly with the Debt Snowball.

Your other option is to pay off debt by order of interest rate, paying off the debt with the highest rate first. This is much more mathematically sound than the Debt Snowball, but may lack the psychological advantages of that method. Given that getting into debt is often psychological, paying it off may be just as psychological, and you could use every bit of help you can get!

Two things that may affect your decision on which debt to concentrate on are if your interest rates are going to change soon (such as in the case of an expiring low rate balance transfer offer on a credit card or an adjustable rate mortgage) and if your interest is tax deductible (basically a mortgage or a student loan). If you have an interest rate that might change soon (almost always to a higher rate) you may want to make that debt more of a priority; if you have a loan with tax deductible interest you may want to lower that on your priority list.

~ Execution: Once you have a plan, make sure you stick to it! Whether you choose to use the Debt Snowball or pay your debt off in interest rate order, do it. Make sure you pay in a timely manner, because late fees will make paying your debt off even more difficult. If you cannot make a payment on time, contact the creditor immediately and plead your case; they may not be able to do anything for you, but they might–like waiving a late fee. Use online payment options to make sure that your efforts are not felled by the USPS running late. Put the dates of payment in your calendar and make sure you pay on time. Pay something, even if you can’t make the minimums (although I certainly hope you can). Just keep up with those payments!

~ Hacks: You may want to try one or more of these to help reduce your interest rates further or just improve your overall financial situation.

Call and ask for a better rate: In particular, credit cards are often willing to do this. Be persistent, don’t give up, and don’t be afraid to call multiple times or ask for a supervisor or manager.

Zero percent (or at least lower) balance transfer offers: Credit cards often do this for new customers and almost as often for existing–offer a reduced rate (sometimes zero) on balance transfers. Just be wary of fees (A 3% fee with a minimum of about $10 and maximum amount of $75 per transfer is common) and time limits (the rate may be good only for a few months). I would not suggest applying for a ton of cards just for this purpose but there may be times when doing just that is useful.

Debt consolidation: A debt consolidation loan combines several (if not all) of your debts into one loan. If the loan has a low rate, that can make paying it off easier than the multiple loans that it replaced, and if the interest happens to be tax deductible (as could be the case with a home equity loan or a refinanced mortgage), all the better. However, be very, very careful with these kinds of loans! If you consolidate your debts and then go right back to racking them up–like clearing your credit cards and then running up high balances again–you end up in an even worse position than you were before. Also, be careful using your house as a piggy bank–the last thing you want is to lose that!

Paying off your debt is clearly one of the most important pieces of your personal financial puzzle. You absolutely must get a handle on your debt early on while working on your finances. Coming up with a strategy and sticking to it are absolutely essential to tackling your debt; you can use some of the hacks above to try to reduce your interest rates or otherwise improve your financial situation. Go, go, go on debt payoff!

Tags: Budgeting, Credit cards, Debt, Frugality, Goals

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