By Krista McBeath, McBeath Financial Group
To improve your financial situation, the first thing to consider is reducing your debt load. A number of strategies can be used to pay off debt. However, before starting any debt payoff strategy (or combination of strategies), be sure you understand the terms of your debts, including interest rates, terms of payment, and any prepayment or other penalties.
Understand Minimum Payments
You are generally required to make minimum payments on your debts, based on factors set by the lender. Failure to make the minimum payments can result in penalties, increased interest rates, and default. If you make only the minimum payments, it may take a long time to pay off the debt, and you may have to pay large amounts of interest over the life of the loan. This is especially true of credit card debt.
For credit cards, the minimum payment is usually equal to the greater of a minimum percentage multiplied by the card’s balance (plus interest on the balance, in some cases) or a base minimum amount (such as $15). For example, assume you have a credit card with a current balance of $2,000, an interest rate of 18 percent, a minimum percentage of 2 percent plus interest, and a base minimum amount of $15. The initial minimum payment required would be $70. If you made only the minimum payments (as recalculated each month), it would take you almost 10 years to pay off the debt, and you would pay a total interest of $1,314.
For other types of loans, the minimum payment is generally the same as the regular monthly payment.
Make Additional Payments
Making payments in addition to your regular or minimum payments can reduce the time it takes to pay off your debt and the total interest paid. For example, if you made monthly payments of $100 on the credit card debt in the previous example (the initial minimum payment was $70), it would take you only 24 months to pay off the debt, and you would pay a total interest of just $396.
As another example, let’s assume you have a current mortgage balance of $100,000. The interest rate is 5 percent, the monthly payment is $791, and you have a remaining term of 15 years. If you make regular payments, you will pay a total interest of $42,343. However, if you pay an additional $200 each month, it will take you only 11 years to pay off the debt, and you will pay a total interest of just $30,022.
Another strategy is to pay one half of your regular monthly mortgage payment every two weeks. By the end of the year, you will have made 26 payments of one half the monthly amount, or essentially 13 monthly payments. In other words, you will have made an extra monthly payment for the year. As a result, you will reduce the time payments must be made and the total interest paid.
Use a Debt Consolidation Loan
When planning your debt reduction strategy, pay off the highest interest rate debts first. First, make the minimum payments required, and then allocate any remaining dollars to the debts with the highest interest rates.
If you have multiple debts with high interest rates, it may be possible to pay off those debts with a debt consolidation loan. Typically, this will be a home equity loan with a much lower interest rate than the rates on the debts being consolidated. Furthermore, if you itemize deductions, interest paid on home equity debt of up to $100,000 is generally deductible for income tax purposes, thus reducing the effective interest rate on the debt consolidation loan even further. However, a home equity loan potentially puts your home at risk because it serves as collateral, and the lender could foreclose if you fail to repay. There also may be closing costs and other charges associated with the loan.
Eliminating excessive debt is the first step in planning your financial future.
Krista McBeath is the founder and president of McBeath Financial Group in Normal. The firm covers all areas of financial management, specializing in retirement and financial planning solutions. For more information, you may call 309-808-2224, e-mail krista@mcbeathfinancial.com, or visit their website at www.McBeathFinancialGroup.com.
Fee-based financial planning and investment advisory services are offered by McBeath Financial Group, a Registered Investment Advisor in the State of Illinois. Tax preparation and insurance products are offered through McBeath Tax and Financial Services, LLC. McBeath Financial Group and McBeath Tax and Financial Services, LLC.
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