Chapter 4: Delete Your Debt
If you currently owe money on credit cards and/or personal loans, it is a good idea to develop a plan to repay them as quickly as possible. Finance charges make holding onto balances extremely expensive. There are several methods you may be able to use to delete your debt efficiently.
Are you just making the minimum required payments now? Minimum payments are often set very low, and you may be able shave years off your debt repayment time just by paying extra. If you have multiple accounts, it is better to be systematic and focus your extra payments on one creditor at a time instead of sending a little extra to all of your creditors. (Of course, you should continue to make minimum payments to everyone.) Many people like to start with the debt with the lowest balance because it will be paid off the soonest, providing gratification that makes it easier to keep going. However, you will save the most money by starting with the debt with the highest interest rate. Once the first debt is paid off, put that money toward the debt with next lowest balance or highest interest rate and so and so on until all of the debts are paid off.
If you feel that you currently don’t have any spare cash lying around, take a close look at your budget. Are there any expenses that can be cut or reduced, like dining out or cable? Do you receive periodic sources of income, such as a tax refund or bonus, that you can direct toward your debt even if you can’t afford to pay extra on a regular basis?
As the name implies, a balance transfer is the transfer of the balance from one credit card (or another type of debt) to another. This could be a good option if you are able to get a card with a lower APR than what you have now. The lower your interest rate, the more of your payment that goes toward principal and the sooner you will be debt free. However, before you do a balance transfer, be aware that most creditors charge a balance transfer fee. If the interest rate on the new card is only slightly lower, the savings may be negligible.
It is better for your credit score to keep old accounts open when you do a balance transfer. However, make sure to use them responsibly. If you charge them up and cannot pay off the balances in full each month, you could wind up with more debt than before.
If you are a homeowner and have equity in your home (owe less on your mortgage(s) than the home’s value), you may be able to use some of that equity to pay off your unsecured debt. Not only is the interest rate on a mortgage usually lower than for unsecured debt, but, in most cases, the interest paid is tax-deductible as well. Besides selling, there are two basic ways you can take the equity out of your house:
- Cash-out refinance – With a cash-out refinance, you take out a new mortgage for an amount greater than the balance on your existing mortgage and get back the difference in cash. For example, you owe $240,000 on your mortgage and refinance with a $260,000 mortgage – you receive $20,000, which you could use to pay off your debt. Keep in mind that you typically need to have good credit to refinance, and there is a limit as to how much equity you can take out. (Doing a traditional refinance is another option. You won’t receive any cash to pay off debts, but if you can lower your mortgage payment, you will have more money to send to your other creditors each month.)
- Second mortgage – A second mortgage is a loan or line of credit that is taken out against your home in addition to the first (or primary) mortgage. If you take out a home equity loan, you receive a lump sum at closing. If you opt for the home equity line of credit, you can withdraw from it repeatedly over a set period of time. Like with refinancing, you usually need to have good credit to be approved, and there is a limit as to how much you can borrow.
Think carefully before you decide to refinance or take out a second mortgage to pay off debt. Both options come with fees that can cancel out your potential savings. Furthermore, if you are spending more than you make, tapping out the equity in your home to pay off consumer debt is a short-term solution that can put your home in jeopardy of foreclosure. Many people get into trouble by using their home equity to pay off unsecured debts, then running up the credit cards again. That pattern leads to a very difficult situation: no home equity, high debt, and the inability to make payments on both secured and unsecured financial commitments.
Debt Consolidation Loan
Another possibility you may have is consolidating some or all of your debt into a new loan. Many financial institutions offer unsecured loans specifically for debt consolidation. The advantage is that you have one convenient payment, and if your credit standing is good, you may be able to get an interest rate that is less than what you currently have. However, if it isn’t, be prepared to pay more.
Like with a balance transfer, cash-out refinance, or second mortgage, if your expenses exceed your income and you need credit to close the gap, a debt consolidation loan is just a short-term solution that may not benefit you in the long run.
Debt Management Plan (DMP)
DMPs are administered by credit counseling agencies. You make one payment to them, and they distribute the money to your creditors. For people with multiple accounts, being able to make one payment can be a relief. Furthermore, many creditors reduce or even eliminate interest rates and fees for borrowers on a DMP, so less money goes toward finance charges and more goes toward the principal. Because you are required to suspend further use of your credit lines when on the plan, there is not the risk of getting further into debt like there is when taking out a loan. In order to participate in a DMP, you must first complete an hour-long session with a counselor, who will examine your financial situation and see if it is an affordable and beneficial option.