Personally, I’m not against debt per se, it would be very difficult to buy a house or fund large investments without debt. And when you think about it, we can benefit from the debt cycle as much as be sucked under because of it, after all we loan our money to the bank for a return in interest.
To achieve the dream of debt free living, the key is to create a debt reduction plan tailored to your circumstances and to stick to it. To get off the debt cycle, it is also essential not to incur more debt, while paying off the old debt. This is why we created a savings plan last month, before tackling debt, so that you have a backup fund for emergencies rather than relying on credit. How much can you afford to repay off your debts? This is where your expense tracking and budgeting from the last two months come in.
1. Face your debts
Don’t throw statements or overdue notices straight in the bin, hoping that the problems will go away. Face your debts by making a list of all your existing debts. Write them down. Include the balance, interest rate and monthly repayment amount. Add any notes such as late payments problems, debts that are being chased, overdue amounts etc.
2. Create a debt reduction plan to systematically reduce your debts
Using one or more of the methods below, tackle your debts. The best method is the one that works well for you. You may choose the snowball technique, where you continue to pay the minimum balance on all of you debts except the one with the smallest balance, where you pay extra. Or you may choose to pay extra on the debt that is most overdue.
The important thing is to pay more than the minimum amount on at least one debt. Why? Let’s look at an example:
If your credit card interest is 18% and the balance is $2,000 and you only pay the minimum monthly repayment of $35:
- it will take nearly 11 years to pay off your credit card (assuming you never use it again)
- over that period you will have incurred $2,574 of interest (assuming a fixed rate of interest)
Use an online calculator to help calculate loan terms and to see the difference a little extra can make.
If you have been tracking your expenses and have started a budget, you will be able to see where you can make cuts in expenses to pay extra on your loans. Remember it is only short term pain. The satisfaction of paying off debts will be far greater than the loss of a few luxuries now.
3. Automate your debt reduction plan
As with the savings plan, automate this process as much as possible. Use an online bank facility to automatically transfer your minimum amount or the set repayment amount every month, or better yet, every pay day. This way there are no late fees to impede your progress, and you don’t miss the money that you don’t see.
4. Communicate with lenders and negotiate terms
Don’t ignore lenders. While many may seem like sharks (ok, many are sharks), they have lent to you in the good faith that you will repay them. Communicate your debt repayment plan with them and see if you can negotiate terms for repayment or better interest rates, even if these terms are short term. Many large lenders will facilitate you in genuine need, especially if they can see that you are making an earnest attempt to get control of your debt situation. And if they don’t, it doesn’t hurt to ask.
Debt Buster Options
Debt consolidation is where you roll all of your existing debts into one. There are a few pros and cons to debt consolidation.
The pros of debt consolidation are:
- Consolidation extends your repayment time
- Reduces your monthly payments
- Reduces compiled interest rates
- Improves your overall cash flow
- One loan repayment a month
Conversely, the cons of debt consolidation are:
- Consolidation extends your repayment time meaning you can end up paying much more than if you didn’t consolidate
- Many fixed term debts have a penalty clause if you make early or additional repayments
- Transition fees
- Many consolidation loans ask for a deposit
- If you use your house or car as security and circumstances change where you find you can’t make the repayments anymore, you could lose your car or house
- If you go through a debt consolidation company, then you are paying a premium for the middle man – an amount that could be going towards your debt.
- There is the risk of building more debt. Having a reduced payment can lure you into a sense of false security. If you’re not disciplined with your finances, you may find your old credit cards are back to where they were before you consolidated. You are then paying the consolidation loan off as well as your new debt.
The amount of interest you pay on debt is a combination of the rate and time or loan term. Even with a lower interest rate, the more time it takes to pay off your debt, the more interest you end up paying in the long run.
Transferring to a zero balance credit card
To be honest, it seems to me that zero balance transfers have dried up since the GFC. But generally, a zero or low balance transfer is where you transfer your existing credit card debt to a credit card that offers zero interest or very low interest for a fixed period of time.
Things to keep in mind include:
- What is the interest rate once the zero balance period is over?
- Will you be happy with the credit card once the zero balance period is over?
- It’s important not to make purchases on your zero balance card during the free period. These payments will take priority, delaying your debt repayment.
- There is the risk of falling into a sense of false security and wracking up debt again on your other cards. It gives you the false sense that you can just transfer subsequent debt onto zero balance cards without the responsibility of paying off the debt at high interest, however banks tend to frown on multiple transfers.
You can find more information on low balance credit card transfers at Moneyhound.
The maths method of paying off multiple debts
This is where you calculate which debt will incur the largest amount of interest and pay this one off first. It may be the debt with the highest interest rate, or it may be one that has a lower interest rate but a higher balance. Use an online calculator to work out which debt will incur the most interest.
Once you have worked out which debt will cost you the most, you continue to pay the minimum balances on all debts and throw as much extra money at the high cost debt as possible to pay it off in the quickest amount of time. Once this debt has been paid off, you then add the minimum repayment amount on the first debt (plus the extra repayments made) to the minimum amount on the next debt and so on.
The snowballing method of debt repayment is similar to the one above, but rather than choosing to knock out the debt that will cost you the most, you start with the debt with the smallest balance. This is less about maths and more about psychology and motivation. It took me a while to see the sense in this method, but I can understand now the motivational power that little kick can give you when you pay down a debt.
Snow flaking is something that you can do on top of snowballing or any other debt reduction method. Basically snow flaking is reducing your debt by putting any and all small amounts directly towards your debt repayment. No amount is too small. This is quite effective because of the compounding principle, the more small amounts you apply towards debt, the less interest you pay overall, and the quicker it is to pay it off.
This debt repayment method was popularised by Adam Baker of Man v Debt. Rather than paying off debt according to highest interest rates or lowest balance, you choose which debt to pay off first according to it’s emotional impact.
The example that Adam gives is comparing a debt to a family member, where the debt is causing a relationship breakdown, to a debt to a bank that is incurring interest. Under the other two repayment methods, the debt to the bank may be the ‘best’ choice to tackle first. Under this method, it makes more sense to ease the tension with loved ones by paying that debt back first.
Alternatively, you may have debt collectors hounding at your door, or debts from pawned goods or high interest debts from cash advance companies. These might be the ones worth tackling first.
I’ve always been a maths person. It’s always been about the numbers to me. Despite this, this method of paying of debt just makes so much sense. If you have debts with high emotional impact (it’s probably not that relevant if all your debts are credit cards etc), then this may be the method of paying off debts that is right for you.
The combination method
There is no reason why you have to use one method exclusively over the others. You may decide to transfer your credit card debt to zero balance card, then snow flake your balance away. You may choose to pay off the debts with the highest emotional impact first, before switching to paying off those with the highest interest rate. Choose what works for you.
As a final note, remember that the key to paying off debt is not to incur more consumer debt. Get out of the endless cycle of debt. This is where tracking your expenses, keeping a budget and creating a savings plan all come in. With these tools and a debt reduction plan, you will be able to become debt free and in a much quicker time.
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