Nobody likes owing money. And most of us who do owe money fall into debt without realizing what a threat those debts are to the security of our financial future. To make things worse, many times we find ourselves in hock without fully understand how this situation came to pass or what to do about it.
We create many of our own debt problems as the result of our own financial behavior or lack of planning. But sometimes stuff happens and we feel like the only way to get through it is to borrow money today and hope for the best.
I understand this of course but based on my experience “hoping for the best” is a dangerous financial plan. What follows is a deep dive into the five worst kinds of debt to have and steps you can take to eliminate the problem. Let’s get to work.
Credit Card Debt
If you carry a credit card balance it’s a sign that something is wrong in your financial life and you need to address the issue immediately. While many people are able to finance credit debt balances at 0 percent interest for a period of time, sooner or later that game will end. When it does, you’ll be forced to pay sky-high interest that will sap your ability to ever build a financial future for yourself or your family.
You know what? Put aside the interest expense. If you carry a credit card balance that you can’t pay off each month it most likely means that you spend more than you make. If you keep that up, you’ll find it almost impossible to ever put anything away for your future and that means you’ll work for the rest of your life and you’ll be limited to how much you can help your family. That is the greatest cost of credit card debt if you ask me. I say that because the mental anguish of being stuck permeates other aspects of life and just sucks the fun right out of everything. Yuk.
OK. So how do we solve this problem? Glad you asked. Here’s how:
a. Stop Making Things Worse
If your credit card balance is growing (even slowly) it’s time for drastic measures. The first thing you must do if you want to get out of a hole is to stop digging and you need to apply that lesson to your spending. Do whatever it takes to take a big chunk out of spending. Here are some ideas:
- Move in with friends or family.
- Take in renters.
- Take on a side job.
- Track every item you spend money on. Have a family meeting and decide together what to cut.
I need to be very clear. In most cases, the first most important step is to determine what the root cause is of your credit card debt and obliterate that. If spending or low income is the issue, get busy. Later on, it may make sense to refinance your debt. But taking on more debt to fix a spending problem is like using gasoline to try to put out a fire. Don’t even think about it Pilgrim.
This is simple to understand – but very hard to do and I know it. But the reality is, unless and until you and your family are willing to make drastic changes in your financial life, nothing will change and your financial security will remain in jeopardy.
b. Restructure Your Payments
Once you’ve plugged your leaking financial ship it’s time to throw down your A game and whittle down the cost of your existing debt. The reason this is so important is because when you reduce the interest cost, you can apply more of your payments towards the principal you owe and thereby get out of debt that much quicker.
Here’s what I want you to do. Prepare a list of all your credit card debts, the amount you owe, the monthly payment you make and (most important) the interest rate you are being charged. If you are missing any of this information, just call the credit card company. Believe me – they have it.
Once you create this spreadsheet you’ll know (among other things) the total you pay in monthly payments for credit card balances. I want you to make minimum payments on all of your cards other than your highest cost debt. On that one, I want you to apply all you have (and then some) to pay off that highest cost card. Once you do, you will reduce your overall interest cost. Then, as you pay off each card, apply that same total amount you have towards the next highest-cost debt.
In other words, just because one of your cards is paid off, don’t reduce the total amount you send to your creditors. The goal is to use that same amount to pay you’re your debts faster and faster as your overall interest rate drops. Rinse and repeat this process until all your balances are paid off. This is known as the “snowball effect” and it works really well if you stick to it.
The one tip I want to share here is that once you’ve paid off a credit card bill, don’t close the credit card relationship. Believe it or not, having credit cards with low or no balances helps improve your credit score big time. I’ll talk more about that in a bit.
c. Refinance Debt
At this point, you have stopped making the problem worse and you’ve restructured your payments to accelerate being debt free. That’s a lot and you should feel pretty good about yourself. The next step is to look for lower-cost alternatives to your existing debt.
You can do this by asking friends and family to refinance, refinancing with other credit companies or even turning to peer-to-peer lending firms like Lending Club, Prosper or debt consolidation companies like Payoff just to name a few. Don’t be shy about shaking all these trees to find a lower-cost lender. Again, this will accelerate the time it will take to get out of debt and speed up the day when you will start saving and investing for yourself rather than making the fat cats in the credit card high-rises rich.
d. Improve Your Credit Score
As your credit score improves you become less risky in the eyes of potential lenders. And when that happens it means they will be willing to loan you money at lower interest rates.
I hinted that one important way to bump your credit score earlier; keep (especially) old credit cards open but make sure the balances are zero or very low. When the credit card companies see a person who has available credit but isn’t using it, they wake up. It means this person will pay their bills and those are the kinds of people these firms like. When you have lots of available credit but use very little of it it’s referred to as a low debt-to-credit limit or low credit utilization. Again, credit card companies go bananas for people with low credit utilization. Take advantage of that friend.
But don’t stop there. Use every technique you can to improve your credit score such as paying your bills on time and having a low debt to income ratio. This is another proxy for risk creditors (especially mortgage companies) use. When they see your total debt is low compared to your income, they’ll play ball with you 7 ways to Sunday.
Another very important way to increase your credit score is to make sure your credit file is accurate. According to the FTC, 1 in 5 credit reports have mistakes. That’s not only unfair, it’s expensive for you. If a would-be creditor reviews your flawed report they might charge higher rates than if they reviewed a corrected credit report.
Sadly, many people overlook verifying the accuracy of their credit file and that’s a real shame. Cleaning up your credit report isn’t that difficult. If you have time and patience, you can get this done yourself. Even if you don’t have the time or patience, you can still clean up your credit report using an inexpensive legal firm. Either way, please make sure your credit report is correct.
Steps C and D are very important and you should pursue these tasks concurrently with step B.
Student Debt
The absolute best way to handle student debt is to never have any. Of course, there are some cases where you or your student simply have to finance education. But most people fall into this trap willingly like the misguided sailor following the siren song which leads the ship directly into the rocks.
Many people graduate college with student debt greater than a mortgage. Many still have to pay for that education well into their 50’s and 60’s. The reason this is so damaging is because those payments on the loan take away from the borrowers’ ability to save for their own future.
If you already carry student debt, you can also take the steps I outlined above to rid yourself of this burden but with some fine tuning:
a. Stop Making It Worse
If you are still in school, do all you can to reduce the amount you need to borrow going forward. If you’ve just started school, re-thinking your situation. This may sound harsh but you really have to ask yourself some tough questions now in order to save yourself decades of paying debt you may have been able to avoid.
Are you studying something because you like it or because it will provide the future life you want. Having a good time in college is fine, but when you’re talking about going into the hole by $50,000, $100,000, $150,000 or more, you have to ask if it’s worth it. Even if you are studying something that is in demand, are you studying in the right place? Can you get your degree at a lower-cost school? If you study the facts, you’ll learn that in most cases, your income will not be impacted by where you get your degree.
Along those same lines, take other steps to reduce the need to borrow funds like taking on a part-time job and moving to lower-cost digs.
b. Restructure Payments
Follow the same ideas presented above with respect to paying off your highest costs debts first. The only shift here is it to include ALL your debts in the matrix. In other words, if your credit card interest rate is higher than the student loan, make minimum payments on the student debt while you throw as much as you can towards that high-cost credit card debt. Once you’ve paid off the higher cost loans, get busy and apply that same energy towards your lower cost debt.
c. Refinance
You should absolutely look into refinancing your student debt. And the good news is there are niche lenders who specialize in this particular field.
The only caveat here is to make sure you understand the ins and outs before you refinance. Even if you can get a lower rate, it doesn’t always pay to refinance. For example, if you refinance a federal student loan using a private lender instead, you could lose valuable benefits such as income-based repayment plans, generous loan forgiveness options and/or loan deferment or forbearance. Check it out before taking the plunge.
d. Improve Your Credit Score
If you are saddled with large student loans, it’s going to weigh down your credit score. That means it will be more expensive to refinance that debt. It also means it will be more expensive to get a mortgage, credit line and it may even be more difficult to get a job.
You may not be able to vanquish that student debt quickly but that just means it’s more important than ever to take any steps you can to bump up that credit score as much as possible. I’ve already outlined a few of the steps you can take to do that. I’ve also written a number of posts that specifically walk you through how to get this done. Make sure you carve out time to work on improving your credit score. Be patient and relentless. It will pay off Pilgrim.
Auto Loans
Auto loans are sneaky because they usually carry a low interest rate – at least that’s how it looks. You never really know what the rate is on a car loan unless you compare the all-cash price of the car to the price of the car if you finance it.
If you confirm that the rate is indeed low, taking a loan to buy a car might be very smart. The low rate you enjoy should enable you to apply more money to paying off higher cost debts or – better yet – save and invest.
The one pitfall you need to avoid is refinancing a car or financing a used car. The rates finance companies charge for these loans are shameful and scandalous. Try to avoid refinancing a car loan and/or financing a used car if you can. If you can’t avoid it, take the steps I suggest you take to get out of credit card debt above.
At the same time, look at your overall financial situation and ask yourself what you need to do in the big picture to turn the situation around. Slash spending? Earn more?
Think out of the box and be ready to take dramatic action. It’s highly likely that if you are having financial problems with your transportation, you are probably having other financial difficulties that need a big picture approach and solution.
Private Loans
You wouldn’t believe how many emails I get from distraught friends and family members who loan money to people they trust and care and then don’t get paid. I have to admit that I like the idea of going to friends and family to refinance debt. It can be a win-win as long as you make your payments.
But if you don’t live up to your promises, kiss the relationship goodbye. I mean it. There is almost no way to repair a relationship after you’ve shafted someone. Bottom line? Unless you are more than 100% sure you will repay the loan, don’t even think about asking for it.
Pay Day Loans
Don’t get me wrong. I understand that desperate times call for desperate measures. If you have been forced to resort to getting pay day loans, I’m sure there are good reasons for it. The thing is, it has to stop and it has to stop now. The rates charged for pay day loans are astronomical. If you get caught up in pay day loan trap it will be very difficult to escape. That’s because the rates are so high that the amount you owe continues to grow quickly. That’s why there is nothing you need to do that is more important than escape this financial death trap immediately.
Take the steps I suggested above but do them on steroids. Depending on how big the pay day balance is, take massive, drastic action to get those loans paid off in 30 days – max. If you have to sell your stuff, do it. If you have to move, do it. If you have to work 7 days a week, 12 hours a day – do it. Remember that the sacrifices I am asking you to make now will be relatively short-lived. But the pain you’ll have to endure if you don’t get out of this debt swamp will go on and on.
Owing money to others isn’t fun. Sometimes it makes sense but many times it doesn’t. Make sure that if you have debt, it’s the right kind of debt. Debt that is absolutely necessary and helps you earn more down the line. Make sure any debt you have is a smart investment rather than a growing liability.
Arrange your financial life in a way that won’t get you further into debt. Pay off your most expensive debt first and then keep on going until all your debt is paid. At the same time, refinance when it makes sense and maximize your credit score – and don’t forget to clean up the errors that are tucked away in that credit file that artificially result in you paying higher rates.
Getting control of your financial future requires patience and fortitude. Gather your strength and willingness and take the steps outlined above. The benefits of doing so will manifest far sooner than you can even imagine.
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