An Introduction to Debt Management

This subject is close to my heart. It is debt management, and the reason it's close to my heart is because this was a large motivator for me to pursue finance as a career.

While I was in the Air Force, there were lots of people who were absolutely shameless about debt. When you're in the military, you can go to any car dealership, and they will sell you a car. It does not matter what the price is; they will get you financing because you will have a steady paycheck. And for those of you who have not been in the military, it's possible to get in trouble for failing to pay bills or generally being an upstanding citizen. Car dealerships have a pretty good guarantee that you will make the payment if they can saddle you with it.

There was also the inclination to spend on credit cards while on work trips because they felt they might not have the opportunity for this particular venue again, among other reasons.

Suffice it to say, I was exposed to a lot of people in debt. It drained people's bank accounts, and that's true whether they're in or out of the service, right?

So, today is about debt management. What do I mean by that?

It's just like it sounds: debt management is about making debts manageable.

Debts have a significant effect on any budget and as such are often the starting point for any financial plan.

These are some questions we are looking to answer:

• How do we remove debt from your budget?

• How can we free up your income to start moving towards your savings and goals instead of the car or the card?

• How can we simplify your bill paying?

• So where do we start, or what do we prioritize paying off?

It can be overwhelming if you are in debt and not making enough money to pay your debts quickly. Still, the solution to any problem begins with finding a starting point, and where I usually start is the interest rates.

Generally speaking, the highest interest rate will be the one you want to target first.

There are some exceptions to this, and it is a judgment call, but all else being equal, the one with the highest interest rate costs you the most.

But what if all else is not equal?

Let's say you have a $200 credit card with an interest rate of 22% annually, or $44 a year.

If you have a $10,000 credit card with a 10% interest rate, it will cost you more—$1000 a year.

So now, despite the very high interest rate (as I am revisiting this, rates are now 28% or more!), the other, lower interest rate card is generating more interest. In this situation, I would pay off the smallest payment first because it removes it from your slate rather than because it has the highest interest. This choice is, again, a judgment call. The smaller balance is more easily handled, and simplifying one's expenses makes them easier to tackle.

The judgment call should prioritize simplification and elimination. It doesn't sound like much, but paying $10 a month of minimum payments to that $200 credit card is not effectively paying the credit card off. The minimum payments are designed to get as much interest out of you as possible. On top of that, it is one more thing on your mind and one more thing clouding up your decision-making process.

So often, if a client has many smaller debts, I advise paying those off each paycheck, which someone can usually do. I have found that if someone is in credit card debt in the first place, it is unlikely that they are going to have the capital to pay off a large credit card balance in one or two paychecks. That happens, but it's it's not usually the case. Removing these smaller debts first can free up your income, allowing you to roll those payments into the larger ones.

Perhaps you only free up $10 from the first smaller debt, but that's $10 now going towards your larger debt. And that's $10 each month that you're not paying interest on.

That's the hard part about this. Many earn a lot of money and not understand debt and interest, creating a huge expense they have somehow accepted as necessary. Others are not making much money, but they've collected this debt over a long period. No magic answer or panacea will make it easy, and we are not taught the dangers of interest and debt in school.

Often, the only course of action is to pay it all off, one payment at a time. Despite this solution being the simplest, it is often the hardest and even excruciating.

Luckily, we can use some other methods to make the debt manageable.

These methods consist of refinancing in some form or another; thankfully, if your credit is poor, this might still be an option for you. It is taking on a new loan to lower your total payment, and this is especially useful if most of your debt is on credit cards. Credit card debt is arguably the worst kind of debt outside of payday loans, and it would behoove you to rid yourself of it.

A consolidation loan is a personal loan solely for consolidating existing debts. The difference between a personal loan and a credit card is that a personal loan is what is called an "amortized" loan. Amortized means the loan has a schedule: the loan requires a set payment for a set number of years, and then the loan will be paid. The principal and interest you pay during each payment change, but the payment amount doesn't change.

An amortized loan allows you to take a variable expense, the credit card payments, and turn it into a known, fixed cost. As a bonus, you will know exactly how much interest you will pay. So, when you take that debt from a credit card to a personal loan, you are taking that growing interest payment and packaging it into something where the interest has already been accounted for, so with each payment, you are truly paying down your loan, which is excellent.

There are some dangers with this.

I have seen people refinance and revert to the same spending habits using those cards.

They think, "Great! Now I don't have this looming credit card debt." But then they keep using those credit cards and double down on their debt. Now, they have this personal loan with the credit card debt they refinanced, as well as the credit card debt again. They failed to make the proper changes and are now in a worse position than when they started.

Another situation that is less of a danger is a requirement to take out more than needed for the refinance. Sometimes, as a part of the loan, the bank will require that you take out more than is necessary while stating minimums or some other such policy. When that happens, if it's non-negotiable, I suggest putting that extra capital straight back into the loan. Make an additional payment. That way, you're not tempted to put yourself more in debt with the pseudo windfall.

I've been harping on credit card debt, but refinancing is great for any high-interest debt.

As you may or may not know, interest rates are very high right now. It may not feel as bad if you buy a car or something small, but when you buy a house, a tiny change in the interest rate will become many thousands of dollars.

It could be that your house payment is starting to feel a little overwhelming, or maybe an old personal loan (interest rates for which are often high, but not so much as credit cards) has become a heavy player in your thinning budget. Refinancing during a time of lower interest rates is a great way to free up your income and make your budget more manageable. There are always costs associated with taking out a loan, such as origination fees; you will usually save money by doing it anyway. It helps because if you don't have the funds to make extra payments towards the principal, you'll pay the interest until the very last payment.

There are some scenarios where, assuming you are close to paying off the loan, you could refinance to pay the same amount of interest throughout the new, refinanced loan. This can happen despite a lower amount of principal and a lower interest rate. This is because of how the payments on an amortized loan are calculated.

When you amortize a loan, the bulk of the interest is paid during the earlier payments. As you approach the last few payments, you're paying less interest and more principal, down to pennies on the dollar.

When you refinance the loan, the new payment will be calculated on the new principal balance, the new term, and the new interest rate. In some cases, because of the extended timeline and because the interest comprises more of the earlier payments, you will end up paying the same amount or even more interest despite a lesser principal amount and interest rate.

You might still do this to free up your budget, as the payment will usually be lower. However, I do not suggest this to everyone because it encourages the abovementioned doubling-down scenario.

Sometimes, however, people get into situations where they are so encumbered by their monthly payments to debt that they have no financial flexibility.

Let's say you are refinancing your car to this end. You may have only three years left on a five-year loan with a $500 payment. You now owe less principal than when you started because you've been paying on it for two years, so the refinanced payment might become, for example, $200 at a five-year term.

This is easier to conceptualize as a rubber band: the same amount of material is present in the entire rubber band (the principal), but you are stretching it out, so there is less in any one spot along the rubber band (the payment).

Now, you will have the loan for longer, but that extra money in your budget each month might make it easier for you to get out of debt in other ways. That goes for any debt refinanced this way.

It is good to talk to a professional about this, and you should take time to consider these options before acting. The bank will want you to re-up your debt, even more so if you refinance at a bank other than the one you originally borrowed from. In fact, the new bank has an additional incentive because it will collect the interest payments you were paying to the original bank. So be cautious and do your homework.

More often than not, someone refinancing a credit card will have several such debts. Rather than get a small personal loan for each one, they can roll all of those debts into one manageable payment. A consolidation loan is simply a personal loan for that purpose.

For example, 8 $200 credit cards (with respective payments) can be condensed into a single $1600 loan with a much lower interest rate. Not only are the numbers more favorable, but management is also simpler.

The issuing bank may require you to close those credit cards as part of that loan, and you should likely take that deal after carefully considering every option.

A similar method is a balance transfer. Banks use This common offer to issue new credit cards, moving the balance of several old cards onto one card with 0% interest for a year. This can be a great tool, but you MUST pay it off in that year, or interest will be retroactively charged on the entire amount. They're also going to charge you an up-front transfer fee in the realm of 3%. Notably, this is not a free method either.

You might have heard people rolling credit cards into other credit cards, saying, "I don't actually have to pay it off." This is simply wrong.

Eventually, that gravy train stops, and they're left with a mountain of credit card debt that no one will refinance because they can see the history of you refinancing it.

Suppose you have a house and some equity in it. In that case, something you might do similar to a consolidation loan is get a HELOC, or Home Equity Line of Credit. A HELOC is a home equity line of credit, and it's a form of "rolling credit" like a credit card. However, the interest rate will be more favorable because it's backed by your house, while a credit card is not collateralized by anything.

I understand that this is scary to many because by using your house as collateral for the loan, you are putting the house at risk. Still, you're using the house as collateral for your mortgage unless you're completely paid off.

Your HELOC rate is almost always going to be phenomenally better than your credit card, so this might give you some breathing room and some HELOCs will even give you an option to lock in an interest rate and make it an amortized loan. This will make that payment way more manageable. You will be charged interest and likely an annual fee, but it is important to remember that manageability is one of the goals here. You are freeing up income and paying down debt, giving yourself the flexibility to make the proper moves.

The next strategy, and the one you should use if you can, is aggressively paying down the principal. You can pay down the principal in advance of your amortized schedule, drastically reducing the cost of interest. I mentioned earlier that when you schedule a loan, you start off paying a lot more interest than you do in the end. Let's take another look at this.

As a simple example, your monthly payment schedule may look like this:

Loan Payment Interest Principal

$3,162.03 $1,875.00 $1,287.03

$3,162.03 $1,871.78 $1,290.25

$3,162.03 $1,868.56 $1,293.47

$3,162.03 $1,865.32 $1,296.71

$3,162.03 $1,862.08 $1,299.95

You can see that the interest is slowly decreasing and the principal is slowly increasing.

When you make payments towards the principal, it removes more of the balance on which the interest is calculated. This is the concept behind the double mortgage payments strategy, and while this is where I hear it most often, the idea works for any debt. Even with credit cards, if you pay if you pay more upfront then you're going to be charged less interest.

This effect is more dramatic the more cash you can throw at it. You can combine strategies and start with the smaller debts as mentioned earlier. You can then roll those smaller payments, that $20 credit card payment for example, into the next one. This is the the best and most efficient way to eliminate debt if you can do it. The other methods are to make this main method more actionable.

So these are the techniques for managing your debt, and once your debt is manageable you give yourself the flexibility you can pay down your remaining debt faster.  

Your next step should be contributing to your emergency savings as soon as you can. While it shouldn't be at the expense of staying current on your payments, your emergency savings will keep you from falling back into the debt you've worked so hard to pay off.

What I often see is someone who doesn't have emergency savings will have a large expense come up, such as vehicle repair, and find themselves unable to pay it. Out comes the credit card, and without the capital to pay it off this credit card debt hangs around, and the next event happens and gets paid for by the card. You see where this is going.

Developing the discipline to contribute to emergency savings is important for staying out of debt because it is what keeps your plan from derailing. Having earmarked funds to pull from for unexpected expenses is what keeps your plan on track.

We'll discuss emergency savings and how to plan for them, as well as how much they should be, in a future post. I don't have a book recommendation here, but if you're curious about any of the terms that I've used, you should visit investopedia.com. The site explains many complicated financial topics in relatable terms, and its articles are well-written, so definitely go check it out.

Thanks for your interest!