In last week’s article, I discussed two strategies for reducing/eliminating credit card debt. These strategies involved turning credit card debt into a fixed payment loan and accelerating credit card debt payoff by paying an additional $5 each month over what was paid the previous month until that credit card debt is paid off. In this article I intend to look at ways of combining both strategies, along with additional strategies, to eliminate all your debt.
Before continuing, I wanted to reiterate that debt is not always a bad thing. As stated in the first article on “Understanding debt: The Credit Card Trap”, accredited investors have learned to use debt as one tool in their wealth building tool bag. The most successful accredited investors strive to learn everything they can about how debt works – how it can work for them and against them. Accredited investors understand when to use debt appropriately when considering various investments. They understand how compounding interest earned on investments is one of the best means of creating wealth and compounding interest paid on debt is usually one of the biggest enemies of creating wealth.
Most people don’t use debt as a means toward generating wealth, but instead get stuck in a trap of increasing debt. With unproductive debt, these people don’t have much chance of creating true net wealth. It is for this reason that I wanted to share my personal strategies toward eliminating debt. Once debt is eliminated, then you can consider using debt for short term needs and for wealth building purposes. Alternatively, you can consider building wealth without using debt – live debt free. Now before exploring debt elimination strategies, lets look at the various types of debt many consumers hold.
Typical debt held by consumers
Many consumers hold credit card debt, a car loan, furniture or electronics debt, department store debt, and home loans. Some debts are fixed with a set number of equal monthly payments (i.e. car and home loan), some have varying monthly payments (i.e. credit cards), some will delay requiring any initial payments for some period of time (i.e. furniture and electronics loans). The interest rate charged for these different types of loans can vary significantly with home and car loans usually being low while credit cards, furniture and electronics, and department store debts are usually very high. With all of these differences, it can be confusing knowing where to begin eliminating debt. I have a simple test that can help.
Conventional methodology for prioritizing debt for elimination
Many financial advisors like to prioritize debt elimination based solely on ranking those debts with the highest interest rate to be paid first. The rank continues from debts with the highest interest rate down to debts with the lowest interest rate to be paid last. This is a good strategy, but personally I like to consider something I’ve made up (it may have been made up elsewhere but this is what I use) called the net debt payment to debt ratio.
Net debt payment to debt ratio
A quick way to prioritize which debt to eliminate first is by comparing the ratio of net debt payment to debt balance for each. This is a simple ratio to help determine those debts where the current monthly payment has the highest impact toward paying off debt. We’ll now look at how to determine this ratio for all of your debts.
For each of your debts, look at a recent bill to see what amount of the last payment went toward paying off the debt. I’ll call this the net debt payment since much of your monthly payment may go toward things other than paying down the debt. Now create a table in Excel or other spreadsheet software with five columns – Name of debt, current balance owed, Net debt payment, Net debt payment to debt ratio, # monthly payments remaining (if applicable), monthly interest rate (divide yearly by 12 months). Put a calculation in the Net debt payment to debt ratio column that divides the net payment column value by the total debt for each item. Set the format of that column to be a percentage. Once completed for all debts, then look for those debts with the highest ratio. Those are your top candidates for elimination. However, you should consider other factors in helping determine your prioritized list.
Other factors to consider when prioritizing debt for elimination
You also need to consider the interest rate being charged since debts with high interest rates are taking a lot money each month just to pay interest and not toward paying down the debt. Look at the number of payments left as well. Irregardless of what interest rate is being paid, if you only have a few months of payments left, it makes sense to focus on paying those debts off first so the associated monthly payment can be added to the next debt’s monthly payment.
Take your prioritization spreadsheet a step further by adding weights
This part takes some knowledge of calculations within Excel. If you are not comfortable doing that, ask someone you know who is. If that fails, then do these calculations by hand on paper for each of your debts.
Add weights against each of the three measures described so far – 1) the net debt payment to debt ration, 2) the monthly interest rate, 3) and the number of payments remaining. For each of these three measures, you need to determine which one is the most important, second important, and least important. Then within each measure, you need to determine what values are most important to least important. The easiest way to do this is to rank each of these factors, say from 1 to 10 where 1 is good and 10 is bad. Then multiply the results together to get an overall value for each debt. This overall value can then be compared between each debt to prioritize those debts that should be eliminated first. Based on 1 being good and 10 being bad for each measure, the overall weights would then mean to first eliminate those with the lowest resulting overall number and work your way to those with the highest overall number for elimination last. This is a bit too complex for this article, however, I may expound on specific measures and values in a future article. For now, I wanted to present the idea for your consideration to open your mind beyond only looking at debts with the highest interest rate for first elimination. For the rest of this article, lets assume we have decided to use the highest interest rate methodology for debt elimination. That typically means credit cards and some other debts like furniture, jewelry, electronics, and department store debts are the highest interest debts. We would then focus on reducing those debts first.
Remember from the previous two articles that many of these types of debts are designed to extend the debt out as long as possible. This is done by lowering the minimum payment each month so less is paid toward debt and more toward interest. These debts can take well over 25 years to pay off if you only make the minimum payment each month. As stated earlier, in last week’s article I provided two strategies to greatly accelerate payoff of these types of debts by using two strategies – 1.) continue paying the same payment monthly for each card which turns them into fixed payment loans or 2.) accelerate payments by adding an additional $5 each month over what was paid in the previous month. You can actually combine both of these strategies to eliminate all of your credit card and other high interest debts.
Using a combination of both strategies to pay off all your credit card debts
It would be nice if you could afford to use the accelerated payment strategy #2 on all of your high interest debts. However, you may not be able to afford this strategy on all of your high interest credit card and other debts at the same time. But, you should be able use strategy 1 of continuing to make the same payment each month on all cards while implementing the accelerated payment strategy #2 on one card to get it paid off sooner. Once you get this card paid off, then there is a third strategy to start in combination with the other two.
Strategy #3: Apply paid off debt payments to the next priority debt
Once you pay off a high interest debt, then apply the same monthly payment that was going toward the paid off debt toward your next priority debt. All the while when the first debt was being paid off using the accelerated strategy #2, this next debt was also being paid off sooner, but not as fast, using strategy #1. By the time the first debt is paid off, this second priority debt will have been reduced as well. Now, with the addition of all payments from the first debt to this second debt, the associated debt balance will be eliminated much quicker. In addition, strategy #2 should now be applied to this debt since it is now your first priority for pay off.
Let’s reflect a second on what is going on here with an example. Assume our first priority debt is a 19.99% credit card with a $2,000 balance. We will use strategy #2 accelerated payments on this debt. Assume the second priority debt is another 19.99% credit card with a $2,000 balance. We will use the fixed payment strategy #1 on this second priority debt.
In last week’s article, we discussed what the monthly payments would be under and resulting acceleration of pay off using either strategy #1 or strategy #2. From this discussion, we know our monthly payment for the second priority debt (and all other credit card debts) using strategy #1 is $40 each month. For our first priority debt using strategy #2, the monthly payment will initially be $40 while it accelerates up to $160 per month after 25 months (just over 2 years). When this first debt is paid off, then the associated $160 strategy #2 payment will be added to the ongoing $40 strategy #2 payment currently being made on the second debt for a new combined $200 monthly payment. Next month the payment will be $205 since this second priority debt now becomes our first priority debt for payoff. Continue applying strategy #2 accelerated payoff on this debt until it is paid, then apply the strategy to the next debt to assume 1st priority position.
Continuing our debt elimination plan using the combination of strategies
As you pay off your first priority debt using strategy #2 acceleration, then combine all previous strategy 1 payments onto the next priority debt. Continue this process until all of your high interest debts are paid. By the time you get to your third or fourth debt being eliminated, you will have a significant monthly payment being applied to the next priority debt. Always applying strategy #2 dramatically accelerates the process of eliminating all of your debts by simply adding $5 more each month toward paying off debt. As mentioned last week, this only increases your monthly payments by $60 each year over the previous year’s payments. After five years of paying down debts, this would be an additional $300 being applied that month ($60 x 5 years). After 10 years, it is an additional $600 being applied that month. These payments are being fully applied toward debt reduction and not toward interest. This is in addition to the increasing reduction of debt being created using strategy #1 on all remaining debts. You can eventually get to paying off your car and home much quicker than planned.
Managing your credit card use
All of these strategies assume you are not increasing the debt on your credit cards during the debt elimination process. Pay for items with cash, or be sure to add an additional payment each month to cover any new purchases made so no new debt carries over into the next month.
Once you have all credit cards paid off, then use them as accredited investors do. They use these cards for short term purchases to take advantage of investment opportunities as they present themselves. Then be sure to pay off the card fully each month or as soon as possible when cash becomes available from whatever the short term investment opportunity was. Don’t let yourself slip back into the habit of accessing your credit without having a plan. In fact, I would create a plan that explains when your card will be used, how long you will carry the debt, and how you will pay it off. Take it further by having a plan for each type of debt. An example would be the opportunity to buy some investment (perhaps a quality artwork at auction) and then a plan on how you will liquidate another investment to pay off the debt and when you will carry out this payoff.
Remember, you need to be in control of your debts and have a keen understanding of how to use it to your benefit before becoming an astute accredited investor.
Copyright 2008 Ole Cram, President of Marcobe Investments, Inc.
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