Last month Todd had advice for staying out of debt. If you’re one of the many who are already in it, this classic Temple column is for you.
In case you're just joining us, we're in the middle of a discussion about debt. Last month we talked about how to stay out of debt. From the letters I've been getting, it's clear that this next part will be even more useful: How to get out.
But before we go there, I need to clarify something. We've been talking about consumer debt, which, for the sake of our discussion, I've defined as money borrowed to pay for something that goes down in value, such as a car, stereo, clothes or vacation. I think consumer debt is a bad thing, as you can tell from all the nasty things I've been saying about it.
What we haven't been talking about is investment debt — borrowing to pay for something that is expected to appreciate, such as a home, a business or an education. By definition, such a loan is an investment. Whether it's a good or bad investment depends on the numbers. So to those of you who felt awfully guilty about your student loans after reading my last two columns, ease up on yourself: In most cases, a student loan is an investment, and not what we've been talking about here. We will cover investment debt, and student loans specifically, in a future column. For now, save the guilt for that credit card bill.
Okay, let's get back to our discussion. If debt is a financial hole, then getting out means making a climb. If you'd like to rejoin the community of surface dwellers, I think I can help. I'm not a credit counselor or financial advisor, but I've been blessed with friends who are. I followed their advice in my personal climb out of the dark depths of debt, and learned a few tricks of my own along the way. Let's walk through the basic steps:
1. Survey the Hole
Most debtors don't even know the extent of their debt. I sure didn't. As the bills piled up, keeping track of the figures became difficult and painful. Difficult because the interest and penalties grew quicker than I could add them. Painful because every statement was a reminder of my failures. The more reminders, the more depressed I got, and the depression robbed me of hope and the will to work out my problems.
That's the worst part of debt. It's not the financial burden. After all, it's only money. What's infinitely worse is the sense of failure — of knowing that you cannot master this very personal part of your life. No one wants to be reminded of that. So it figures that most people don't bother to add up the numbers that comprise their total debt.
Like many remedies, this first step can be painful. But it's got to be done. Gather your latest billing statements, IOU's and anything else that describes a current debt, and stack them into one big ugly pile. Now go through the pile, one debt at a time, making a list of all creditors, the interest rate, the balance owed, and the minimum monthly payment. (By the way, if you have student loans but you're not yet making payments on them, you can leave them off this list for now.)
As you'll see in a moment, the list is easiest to work with if you use a computer spreadsheet program. Each row should contain the information for one debt. Label the columns Creditor, Rate, Balance and Payment. Here's where the spreadsheet starts to come in handy: When you've entered all the debts, calculate the sum for the Balance column. There you have it — the depth of the hole. Ouch! Now let's get to work on your ascent.
2. Consider Your Options
Climbing out of the hole is going to take some work, so you might as well find the quickest route. But first, take a look at the slowest route: Make a fifth column and label it Free. It's about to show you how long you'll have to wait till you're free of debt. For each debt, divide the Balance by the Payment and put the result in the Free column. Assuming you incur no more debts, the highest number in the Free column indicates the distance in months between you and your last debt payment. Ouch again! Chances are, you don't want to wait that long. I don't blame you. I hate waiting. Let's look for a quicker route.
In any journey, the more you carry, the slower you go. The slower you travel, the longer the journey. Duh. So it figures that in this journey, you'll reach the top quicker if you unload your burden as quickly as possible. How? Increase your payments above the minimum. The minimum-payment scheme is wonderful for creditors because they earn interest on your loan for the maximum possible time. Like leaches, they prefer to latch on and suck for the duration. Which means, like a leach's victim, you want to end this relationship as soon as possible. The minimum payment is your enemy. To leave that disgusting parasite analogy and return to our journey, those minimum payments drag the ascent to debt-freedom to a crawl.
To speed things up, you'll need to increase your monthly payments as much as you can bear. Start by calculating the sum of the Payment column to determine what you're now spending monthly to pay off debts. Then take a look at your monthly budget: How much more can you afford? If you really want out of this debt, you'll have to rearrange your priorities: earn more, spend less, postpone investments, sell the Ferrari — whatever it takes to scrape up extra cash for your debt payments. Come up with a figure that's bigger than your current total of payments — how much more depends on how fast you want to get out of debt. My advice is, scrape till it hurts. As any true climber will attest, the view at the top is worth a few cuts and bruises.
3. Unload the Heavy Stuff
When you've figured out how much you can spend to accelerate your payments, make sure you make those bigger payments in the most efficient way. That means starting with your heaviest burdens. With debt, weight is measured first in interest rate, not in volume. To eliminate weight, pay off the highest-interest debts first. Here's how: Reorder your debt list by interest rate — highest-interest debt at the top, lowest-interest debt at the bottom. Now apply all of your extra cash to the first debt on the list.
Wait a minute. Can that be right? Wouldn't it be smarter to pay off the biggest debt first? Or how about the longest debt — the one with the highest number in the Free column? No. And no. Look at this way: You're on a 100-mile wilderness hike. You've packed a small but heavy can of chili and a bunch of bulky-but-light rice cakes. (This is my analogy, so I'll pick the menu.) If you're smart, you'll eat the chili the first night so you won't have to carry that weight the rest of the journey (on your back, at least.) With a lighter pack, you'll travel quicker, and get to that Denny's or Pizza Hut awaiting you at journey's end just that much sooner. (But if you return to civilization and I find out you left that empty can back in the woods, you'll be going back to fetch it. So much for this illustration.)
You've got a load of debt on your back. The longer you carry its heaviest-interest contents, the slower you'll travel, and the longer you'll be paying interest. It does no good to make your pack less bulky if it's still filled with heavy stuff. Pay off the biggest-interest debt first. Then apply the amount of that former payment to the next debt on the list to accelerate its payoff. If you keep working your way down the list in this fashion, you'll be assured of paying the least possible interest. Remember: Every dollar you don't have to pay in interest goes toward the principle on your remaining debts. It's another step closer to freedom ... one less day of being forced to live on rice cakes.
By the way, there are at least three other ways to dispatch your heaviest-interest debts. The simplest is to increase the frequency of your payments. There's no law requiring you to make just one payment on a your credit card debt each month. If you have the cash, make two or three payments per month. Your creditor is charging you interest daily — why not return the gesture? Every additional payment moves up the delicious day of your payoff and lowers the interest you'll pay till you get there.
Refinancing is another weight-loss trick. It's most common with mortgages and other long-term debts, but some credit card issuers offer something like it when they assume an existing debt to entice you into switching accounts. They pay off your current creditor and add that balance to your new account. If you get such an offer with a lower interest rate (and the other fees and fine print don't eliminate the advantage), take it, then reorder your list.
Then there's the consolidation loan, which allows you to pay off several debts with a single, larger loan. Don't take it unless it actually lowers your total debt burden: If it lowers the interest on smaller debts but raises it on bigger ones, you're losing ground. Maybe. If you own a home, talk to your banker about a home-equity loan to consolidate your debts. In some cases, the interest on the loan is tax-deductible — which is no longer the case with most consumer loans. (Some of us miss the '80s.) When you figure in the tax deduction, you may come out ahead even if the interest rate is higher.
The Fine Print
The steps I've described above aren't painless, but they will help you reach your goal quicker. Time is not your friend when you're climbing out of debt. After all, you're renting other people's money, and they charge by the day. Return their money as quickly as possible — and turn in the most expensive rentals first.
Before I close I should mention a few complications. If you've got debts with deferred payment schedules or balloon payments or some other wacky repayment plan, the above debt list won't give you an accurate picture of your debt load. You'll have to fiddle with the figures and formulae to get what you need to know. And of course, it's not designed to track your debts from month to month: To do that, you'll have to enter new balances and payments each month, or add more columns and calculations to make projections. That's a lot of work, so I suggest you simply revise your list every few months, or whenever you have significant changes in your finances — a raise (congratulations), a new debt (shame on you), or an old debt paid off (bravo!).
If you're using an accounting program such as Quicken, you can set it up to track your debts and payments to see how you're doing. The bottom line is, if you use only the simple list I've described above, you won't have every little number affecting your plan, but you'll still have enough information to begin a smart climb.
Last thing. These steps work under the assumption that you've got enough income to cover your payments. If that's not the case — if you're juggling bills, racking up late fees and penalties, screening your calls to avoid that nasty collection agent — you need a different plan altogether. Next month, we'll cover what to do when your debt condition becomes a crisis situation: negotiating with creditors, settling debts and rescuing your credit record.
Even if you're not in that situation, I hope you'll check out the column. Chances are, you know someone in a debt crisis (or someone who's about to go there). What I have to say may help you help them get through it. Jesus showed up in the lives of people who helped me through mine — maybe He's planning an appearance through you too.
Copyright 2000 Todd Temple. All rights reserved.