For many of us, debt is just a common part of our day-to-day lives. However, not all debt is created equal! Before we begin looking at consolidating debt we must first answer the question of, "Do I need to consolidate debt?".The first step is to prioritize debt by interest rate. You should all have a list of ALL of your debt (credit cards, auto loans, home loans etc.) then rank the debt with the highest rate at the top of that list, lowest at the bottom. How much of that debt is being charged at rates over 20%? 10%? 5%? Understanding this will help you answer the question of debt consolidation.
Once you have your list of debt created and prioritized you will have a greater understanding of how much consolidation you need to do and your payoff priority. The following debt consolidation strategies will help get you started on the path to financial freedom:
Change your Spending Habits
There is a reason that you’re having debt problems to begin with! Most people will focus on debt consolidation, which will in theory drop the amount of money they will be paying in interest on debt they already have. While this is true, reports show that those who seek consolidations don’t actually get out of debt! They simply reallocate debt which lowers their payments, giving them the illusion that they have more money to spend!
Focus on High Interest Rate Debt
While not necessarily a debt consolidation method, you should focus on paying the minimum balances on your low-interest debt, and put as much money as you can toward your high interest debt. This method, also called the “Snowball” method, will enable you to get rid of the high interest debt quickly, allowing more money to be allocated to other debt. We offer financial calculators which will give you a better idea of how quickly you can pay off your debt using the Snowball method vs. the way you usually pay.
Utilize Teaser Rates (Balance Transfers)
As we teach in our class on credit, it’s important to keep revolving credit balances low in order to avoid negative marks on your credit report and score. If you have high balances on high interest rate cards, you can utilize balance transfers to move from one card to another. Here’s an example: let’s say you have a Visa card with a $20,000 limit and you are using $15,000 worth of that credit. You are currently making the minimum payments on that card and being hit with a 20% rate on the card. OUCH! That adds up to over $3,000 in interest a year! If you use the teaser rates, you can move that balance over to another card and pay 0% interest for 12-18 months. Essentially using that $15,000 for free for over a year. There will be a balance transfer fee involved, normally 2-3%, but that is far better than 20%. Just remember to pay it off before the 0% period ends!
Get a Line of Credit
If you have done the math and know exactly what rate you’re being charged on average, it may make sense to get a line of credit and pay off your high-interest debt! Lines of credit are not cheap, but if you’re saddled with debt it may save you a lot of money! For example, say you have 3 credit cards that are maxed out with balances totaling $20,000 and an average interest rate of 17%. Shop around and see if you can find a good line of credit for $20,000 with a rate that is lower than 17%. While rates for a line of credit are not going to be cheap, they will be much better than your credit card rates. If you found a $20,000 credit line with 8% interest, you could pay off your high rate cards and save yourself 9%. That’s a lot of savings! On top of that, your credit score will increase because your credit card balances are no longer maxed out, in fact, they are at zero! Now keep them that way!
Refinance Your Home
While we understand that many may not own their homes, we would be remiss if we didn’t add it to the list. Home mortgage rates are historically low and should be taken advantage of. If you do own your home, you may want to look at refinancing your house and taking some of that money to pay off your debt. Rates right now for 30-year fixed mortgages are running around 4%. Some simple math will drive home the savings. Let’s revisit our example of a Visa card with a $20,000 limit where you are using $15,000 worth of that credit. You are currently making the minimum payments and being hit with a 20% interest rate on the card. That adds up to over $3,000 in interest annually! If you used some of the money from your home, refinanced at 4%, you would be paying a little more than $600 a year in interest. I’m not the smartest man in the world but I’m pretty sure you would be much happier with an extra $2,400 in your pocket every year!
The overwhelming key here is to understand how you got into debt to begin with. Consolidating and paying down your cards is important, but what good will it do if you just dig yourself deeper into debt. Benjamin Franklin was once quoted as saying “Rather go to bed without dinner than to rise in debt.” While we are definitely not saying to go without dinner, we have to understand how all our purchases will impact our net worth, debt load and credit score. In our credit class, we focus on many ways to not just pay down your debt but to understand how to build up your credit score, giving you access to the cheapest rates available.
About the Author
Merlin Rothfeld has been actively involved in the financial markets since 1996. After receiving his degree in Business Finance, Merlin worked for a large financial planning firm in California where he applied traditional, long term investment strategies.