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Debt Management
Creating a debt consolidation plan
Five reasons to pay down debt
Are you drowning in debt
Creating a debt consolidation plan
Follow our four simple steps to take control of your finances and pay off your creditors.
If you’ve got a mountain of high-interest debt, you may benefit from taking out a debt consolidation loan. This involves taking out a single, lower-interest loan (often a home equity loan) and using it to pay off all your creditors. That way you can concentrate on one monthly payment and pay off what you owe much faster, at a lower interest rate.
Consolidating your debt can help you get closer to financial freedom. But it takes careful planning and the discipline to follow through. You can make it work by following these four steps:
Step 1: Determine Your Debt Load
Make a list of all of your current debts, excluding your mortgage, and determine what you’re paying on these accounts each month.
Let’s say you have a bank-issued credit card that charges 18% and a department store credit card with a rate of 20%. Two years ago, you also took out a $25,000 car loan with a five-year term at 8%. Here’s what your debt might look like:
Credit card |
$9,600 |
Department store credit card |
$4,200 |
Car loan |
$16,200 |
Total debt |
$30,000 |
Now add up the monthly payments you’re making on these accounts. For your credit cards this may vary, so use an average of your last six months or so. We’ll assume you’re paying 5% of the total balance on the bank-issued card and 10% on the department store card:
Credit card |
$480 |
Department store credit card |
$420 |
Car loan |
$500 |
Total monthly payments: |
$1,400 |
Now you’ve got a clear picture of your situation: when you consolidate your debts, you will need $30,000 to pay off your creditors, and you’ll want your monthly payments to be less than $1,400.
Step 2: Shop for the Best Loan
There are several types of loans to consider when consolidating debt:
- Home equity loans and lines of credit offer the lowest interest rates, because they’re secured with your house. And because they’re a type of mortgage, the interest you pay may be tax-deductible. Following through with the above example, you might consider taking out a home equity loan for $30,000. At 7.5% interest over five years, the monthly payment would be just $600 -- less than half of what you’re currently paying.
- Cash-out refinancing is another option. It involves taking out a new mortgage on your home that’s larger than your current one. For example, if you have a $90,000 mortgage and your house is worth $180,000, you could take out a new mortgage for $120,000 and use the extra $30,000 to pay off your credit cards and car loan. Even if your monthly payment increases, it will still be less than your combined loan payments were before and the amount of interest you’ll pay will be greatly reduced.
- A personal loan can also be used to consolidate your debt if you don’t own a home, or you don’t want to use your home as collateral. The interest rates on these loans are higher than those of a home equity loan, but are usually lower than credit card rates. With a three-year loan at 10%, you could pay off $30,000 with less than $1,000 a month.
When you’re shopping for loans, don’t forget to factor in upfront fees and points as well as interest rates. The loan’s annual percentage rate (APR) is a good benchmark for comparison.
Step 3: Commit to a Timeline
After you’ve found the best loan, sit down and figure out a timeline for paying off your debt.
Home equity loans and personal loans have a fixed term, so you’ll know exactly how long it will take to retire your debt. If you’ve decided to consolidate with a home equity line of credit (HELOC), however, you’ll be required to make only a small minimum payment every month. But paying the minimum will not reduce your debt.
Instead, determine how much you can afford each month. For example, if you borrow $30,000 on a HELOC at 6.5% and feel you can afford $700 a month, you will pay back the loan in about four years. (Remember, though, that the interest rate on a HELOC is variable, so this calculation won’t be exact.) To help you stick to your timeline, consider setting up an automatic monthly withdrawal from your bank account.
Step 4: Control Your Spending
This may the most important step of all. Consolidating your debt only works if you resist the temptation to run up your credit cards again. Getting out of debt is not easy, and it won’t happen overnight. But the rewards of being debt-free are worth the effort.
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Five reasons to pay down debt
Boost your borrowing power and increase your cash flow by paying off part or all of your outstanding loans.
The old adage, "neither a borrower nor a lender be," doesn't apply in today's consumer economy. Still, it doesn't pay to carry more debt than you must. Here are five compelling reasons you should pay down any outstanding loans as quickly as possible.
- You'll pay less total interest. Interest is essentially rent you pay a lender for the use of its money. The longer you keep the money, the more rent you'll pay. If, for example, you borrow $50,000 for 15 years at a rate of eight percent per year, you'll pay a total of $36,009 in interest charges. The same loan amortized over 30 years would cost $82,078 in interest. Refinancing your mortgage or auto loan over a shorter term can save you big bucks -- but only if you can afford the higher monthly payments.
- You'll be able to borrow more economically. When lenders calculate the rate of interest at which you can borrow, they take into account the amount of debt you are currently carrying and your ability to repay it. The greater your debt load, the greater the risk you will default on your payments and the higher the interest rate the lender will charge, to offset the risk. Pay off some debt -- particularly high-interest debt such as credit-card balances -- and you may qualify for a lower interest rate on the rest if you refinance it.
- You'll have greater credit to draw on. When lenders calculate how much you can borrow, they look at the amount of debt you have outstanding now and how much more you can afford to service, given your current income. If you have a big mortgage or a lot of credit-card debt and pay high monthly installments, lenders will be wary of letting you borrow much more. Pay down your debts and free up some cash each month and you'll qualify for more credit.
- You'll have better cash flow. By paying down debt, you'll reduce the amount of your monthly installments going forward. You'll have more money in your pocket for current expenses and extras -- and less need to borrow from high-interest lenders, such as credit card companies, for day-to-day needs.
- You'll reduce your opportunity cost. You could put the money you're paying in interest each month to better use if you pay off your loans. If you deposit the same amount in a savings account, you will earn interest. If you invest it in a home that appreciates in value or brings in rental income, you will make a capital gain when you sell or earn extra income while you are renting it out. You'll be better off by the annual rate of return you make on your investment plus the annual rate of interest you've been paying on your loans.
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Are you drowning in debt?
Here are some sure-fire signs your debt load is too big and you should develop a strategy for paying it down.
You haven’t answered the phone for months, fearing it will be another collection agency calling. Bills are arriving so quickly you don’t bother opening them any more.
If your debt is getting out of control, you need to develop a strategy for paying it off and get yourself back on track to financial solvency and help you sleep at night.
Your strategy may include contacting your creditors and rescheduling the payment of your debts. You may also be able to replace high-interest-rate debts, such as credit card balances, with a home equity line of credit or personal loan at a lower interest rate. Consolidating some of your debts also allows you to replace several monthly bills with a single loan payment.
Consider taking action on your debt load if any of the following statements applies to you:
- You can only afford to make minimum payments on your credit card bills. Most of that payment is interest. It may take you decades to pay for your purchases with this approach.
- You pay off one card or creditor by borrowing from, or taking a cash advance against, another. Borrowing from Peter to pay Paul will only create more debt in the end. And cash advances are much more expensive than other credit card debt.
- You are maxed out -- or over the limit -- on more than one credit card. Most companies penalize you with additional fees if you go over your credit limit.
- You never pay off your entire credit card debt. You strategize about who gets paid each month.
- You put day-to-day expenses on credit. You are charging necessities such as your groceries and gas.
- You have to earmark more and more of your income for debt repayment. Professionals suggest that you should be spending no more than 20 percent of your monthly income on repaying debts (not counting your mortgage or rent payments). If, for example, you spend $1,000 per month on debt repayment and your monthly income is $3,000, you’re spending more than 33 percent of your income on debt repayment. That’s way too much.
- You often pay your bills late. Everyone comes up short occasionally. But you have to triage your bills every month.
- You have insufficient emergency reserves to cover a financial setback. You live paycheck to paycheck, and your savings have long since disappeared.
- You find yourself fumbling to find a credit card that works and post-dating all your checks. You never know which card will be declined or which check will bounce.
- You apply for new credit cards with low introductory rates, and transfer your debts to them. This can be a short-term solution, but eventually, the debt will catch up to you. Plus there may be a fee for transferring your debts. And after the introductory period, the interest rates can skyrocket.
- Bill collectors are calling.
- You don’t know -- and don’t want to know -- how much money you owe. You avoid the mailman. As for actually opening the bills – forget it.
- You lie about your debts. You may still be keeping the truth from your spouse.
If any of these statements applies to you, it’s time to take control now. The first thing you should do is throw your credit cards away, stop spending on anything but essentials and devote all your disposable income to paying down debt.
Then consider:
- Getting a copy of your credit report, or even consider a credit monitoring service. This will give you a concise overview of your total debt and help you prioritize the steps you will take to reduce it.
- Approaching your creditors on a one-on-one basis to ask if you can reduce your payments. This may mean rescheduling the debts, or refinancing them over a longer time period, which will increase the total interest you pay and the time before you are debt-free.
- Applying for a home equity loan or a personal loan to replace high-interest-rate debts with one loan at a lower rate
- Making a budget, that distinguishes your needs from your wants and cutting out spending on extras and luxury items.
- Consulting a credit counseling service. It may come up with a solution that has not occurred to you.
- Selling assets, such as a second car.
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