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When it comes to debt, the Great Recession will be remembered for the turmoil in the home housing market. But when we're talking about debt, the news doesn't always have to be bad. In fact, the time has never been better to reflect on past spending habits and start a plan to get out of debt.
In this article, we're going to attack consumer debt from three angles, all of which are important in creating a viable, long-term solution for consumers:
Before we start that discussion, we're going to run through a quick primer on good debt versus bad.
Good Debt versus Bad Debt
There is the misconception that all debt is bad, and that's simply not true. For many Americans, consumer debt is the only way we can afford to buy a home or pay for college. As long as the household has the financial resources to pay back outstanding loans, debt serves a very useful purpose. With that in mind, here are some rules of thumb when it comes to debt:
Good Debt
Good debt is usually associated with the purchase of an appreciating asset. That is to say, money borrowed to pay for things like a new home or to pay for college is good debt. This debt is more like an investment in the home or an education. These investments are expected to be more valuable in the future.
To a lesser extent, good debt can be characterized as secured loans. These loans are associated with something tangible such as a car. Admittedly, most cars depreciate over time, but loans on the vehicle are paid off too. With secured debt, the home or car can be sold to help pay back the debt owed if the owner ever runs into financial trouble.
Finally, another good rule of thumb is that good debt is usually associated with a low interest loan that is tax deductible.
Bad Debt
On the other hand, bad debt is usually associated with credit cards or other forms of unsecured loans. An unsecured loan is one that is not directly backed by an asset, or something tangible that can be quickly sold to pay off the debt. Credit card debt is a great example of an unsecured loan, and the most economically worrisome source of debt.
With very few exceptions, there is no good reason to carry a credit card balance each month. At its most basic level, you're spending more money than you make each month. If this turns to a habit, then it defies the most fundamental of all rules to stay out of debt:
Household Expenses must be equal to, or less than, Household Income
If you're in the habit of breaking this rule, then chances are you have a lot of bad debt. And with that lesson behind us, let's start talking about getting out of debt.
Credit Card Debt
As just discussed, most credit card debt is really just bad debt. Interest payments are not tax deductible. Card-issuing companies sometimes offer low introductory interest rates. However, account holders often find themselves constantly switching credit card companies to keep their interest rates low.
Paying off Credit Card Debt
It takes some discipline to pay off credit card debt, but it's done all the time. Obviously it's going to mean paying more than the minimum monthly payment. But here are some steps you can take today to start paying off that debt tomorrow:
- Practice Self Discipline - you're either going to have to stop using credit cards altogether, or start limiting your purchases to emergencies or necessities - such as groceries. If you're afraid you'll be tempted to overspend at the shopping mall then cut up the cards.
- Minimum Payments - if you're going to lower your outstanding balance, then you have to start paying more than the minimum payments each month. In fact, we have several loan calculators that can help you figure out how long it will take to pay back the money you owe.
- Organize Your Debt - it might be disheartening, but you need to understand how much you owe. That means organizing all your credit card debt, evaluating interest rates charged, as well as the outstanding balance on each card.
- Prioritize Your Payments - the most financially-sound approach is to first pay off credit cards that charge the highest interest rate. However, many people get a big motivational boost by first paying off a card or two with relatively low balances.
- Lower Interest Rates - finally, sometimes all it takes is a call to your credit card company to lower your interest rate. If introductory offers are in the 0 to 8% range, and you're paying 18 or 20%, then it's time to start negotiating with that credit card company.
Home Equity Loans
Perhaps the single most valuable asset most Americans own is their home. In a robust housing market, many families find themselves with a home worth much more than they paid for it only a short time ago. They are simply awash in home equity.
Unfortunately, many homeowners begin pulling the equity back out of their homes as quickly as it accumulates. The outcome is more debt load on consumers, and increased risk of losing the asset backing those loans - their home. This is especially worrisome if the housing market starts to slow down.
Negative Equity
If you've been taking advantage of the equity you have in your home, now is a good time to stop. A downturn in the housing market can suddenly leave you in a negative equity situation. This occurs when you owe more on your home than it's worth.
Normally lenders will limit the total of all home equity loans to around 80% of the equity you have in the home. But a sharp downturn in home values can leave you with very little, or even a negative equity situation.
Floating Interest Rates
If you have floating interest rates (as in the case of adjustable rate mortgages) on your home equity loans, then you might want to consider insulating yourself from future interest rate increases. This can be accomplished by converting that variable rate loan to a fixed rate mortgage.
Adjustable rate mortgages can be risky in turbulent times. Locking in a fixed rate mortgage is just another way of demonstrating you're committed to paying off your debt.
Biweekly Mortgage Payments
You can also start to accelerate paying off your home equity loans by requesting a biweekly mortgage payment plan. With biweekly payments, you'll be making the equivalent of 13 monthly payments each year.
A 30-year mortgage, carrying an interest rate of 7%, can be paid off 20% faster with a biweekly loan. Our biweekly mortgage payment calculator can help you to evaluate "what-if" scenarios if this type of loan is something you'd be interested in obtaining.
Control Spending with Budgets
Earlier we provided a simple equation showing how household expenses should never be greater than income, especially in the long run. To many consumers "budget" is a word that conjures up thoughts of sacrifice, and keeping track of excruciating detail.
The topic of creating a household budget is covered elsewhere in this publication, along with downloadable spreadsheets and other aids. But there are a couple of rules we're going to talk about in this topic.
Household Cash Flow
One of the fundamental attributes of a financially healthy household is a positive cash flow. We talked about this formula earlier, but it's worth repeating:
Household Expenses must be equal to, or less than, Household Income
This means that cash coming into the home must be greater than cash leaving the home. If your household debt is on the rise, and you can't understand why, then it's time to build a household budget that gets you back in balance.
Discretionary versus Mandatory Expense
When creating your budget, one of the activities you're going to need to go through is categorizing your household expenditures into mandatory versus discretionary expenses. Mandatory expenses are those you really cannot live without. For example, this might include paying back loans, purchasing food or groceries, buying work clothes, and paying for utilities such as water, natural gas, and electricity.
Discretionary expenses are those that contribute to your monthly debt load, but don't have a significant impact on your quality of life. Discretionary expenses include costs such as eating out at expensive restaurants, a weekly visit to the spa, or lavish vacations.
Once you've identified your household income and mandatory expenses, you'll understand what's referred to as your "monthly cushion." This monthly cushion is the money that's left over each month to spend on discretionary items. Understanding the boundaries of this cushion is a key to getting out of debt, and staying out of debt.
About the Author - Getting out of Debt
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