How to reduce your debt?
This year, one of the first couples I sat down with had a new years resolution to get serious about tackling their debt and wanted some help. Although I do not do this type of work often, I decided to help them anyway.
Take stock of your debt
Before the meeting started, I asked Mike and Jacquie to take stock of their debts by completing a questionnaire I call the debt manager. Here’s their debt situation:
|The Debt Manager|
|Name of Debt||Amount of Debt ($)||Interest rate (%)||Minimum Payment ($)||Actual Payment ($)||how long till this debt is paid off?||Comments|
|15 years||monthly payments|
|Line of Credit|
|15 yrs, 6 mos||monthly payments|
|2 yrs, 5 mos||monthly payments|
|2 yrs, 11 mos||monthly payments|
Can they afford the payments?
Currently, they are paying $2235 per month towards these debts. Their take home pay is about $5000 per month which means 44.7% of their take home pay is going to servicing this debt. No wonder they feel some financial stress from their debts.
The reasons their debt payments are high is because they are paying considerably more than the minimum required payment. In their case, putting that much towards the debt may be a good thing because it means they are aggressively paying down the debts.
Strategies to pay down debt faster
Let’s walk through some strategies to get this debt paid down faster.
- Spend less. The root of a debt problem always comes from overspending. It’s so important to fix the overspending problem by spending less. Mike and Jacquie feel like they have this under control and are pretty reasonable with their spending now so their debt does not get out of hand again.
- Consolidation of credit card debts. Jacquie wants to consolidate the two credit card amounts into the line of credit because the interest rates are so much lower on the line of credit. If Mike and Jacquie consolidate the debts into their line of credit, they will have a balance of $50,114.33. If they continue to make the same payments of $900 per month ($250+$500+$150), this loan would be paid off in 5 years and 3 months and their total interest over that period would be $5413.16. This is a significant savings in total interest from their current strategy. If they continue with their current strategy, they would pay over $15,800 in interest on those three loans.
- Using savings to pay off debts. Mike has an ING saving account with $4000 in it making about 1.5%. I suggested that it was mathematically to their advantage to use that $4000 towards the credit card debt costing 18% instead of keeping it in savings at 1.5%. Since their debt payments are much greater than the minimum required payments, they have lots of cashflow cushion in case of emergencies. Paying off the Bay card would immediately save them $1180 of interest over the next 3 years and they could also apply the $150 per month towards the Mastercard to pay it off 6 months quicker.
- Earn more income. Jacquie is not working full time. She has stayed at home to raise their two children and has been working part time for the past 18 months. Now that both kids are in school full time, she feels she could work a little more to pay of the debts a little faster. If she can put an extra $250 per month towards debt payments (assuming the consolidation strategy above), that would knock off the debt 1 year and 3 months sooner.
What you have here is a look at a real life case to help you understand the process of assessing your debt situation and developing strategies to tackle the debt problem. What do you think? Do you have any other suggestions for Mike and Jacqueline?
Debt calculators and tools
To help Mike and Jacquie with these calculations, I used three tools:The Debt Manager Spreadsheet (249 downloads) – This is a simple spreadsheet I put together to help them take stock of their debt and calculate some simple ratios. Feel free to download the spreadsheet use with your own numbers.
Online debt payment calculator – find out how long it will take to pay off debt and how much interest you will pay to do so.
What will it take to pay off my debt – if you have a goal to pay off your credit cards before a specific period of time, you can find out the monthly payment required to pay it off.