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Take this debt and SACK it week 2 – A is for Allocate

'Credit Card Donation' photo (c) 2009, Kevin Botto - license: http://creativecommons.org/licenses/by-nd/2.0/Last week, we embarked on a journey to SACK our debt. In step 1, we took Stock by creating a list of all debts, the interest rate, and the minimum payment on each one. If you’re just joining us now, go back and grab the spreadsheet to fill in here and read the related post here. It won’t take long to catch up.

Now that the list is complete, we need a plan to Allocate our payments strategically. The first part is to remember to…

 

Make the minimum payments on each loan

This is the obvious first step, but it bears repeating because once we start adding to this, I don’t want this point to get lost. If you don’t make your minimum payment, your credit rating will go down the toilet. While tanking your credit rating may seem like an effective way of keeping you out of future trouble by closing the borrowing channels, it is not a good strategy. Renting a home or obtaining a mortgage can be extremely difficult if you have a negative credit rating, so unless you’d like to move to your car (which I hope you haven’t needed to borrow to obtain or you may not have one of those either), do what you can to keep your credit rating intact.

Tackle one loan or credit card at a time

When my father could not pay the entire balance on his credit cards, he instructed me, his teenage bookkeeper at the time, to write cheques for a few hundred dollars to each credit card company “just to keep everybody happy.” This was not a good strategy. A better approach would be to take the extra over and above the minimum payments and apply it to one card or loan. I like to think of this as a snowball. You’re rolling all your payments into one big punch that you’re going to throw at debt #1. When debt #1 is paid off, then you’re going to take everything and throw it against debt #2. When you’re attacking debt #2, your snowball is going to be even bigger because you will be adding the minimum payment from debt #1 to it. Since debt #1 will be paid off by then, you don’t have to pay anything else on it – not even a minimum payment. How refreshing!! As you progress through this strategy, you’re going to gain momentum because your payments will get bigger by virtue of paying off each debt.

Which debt do you start with?

Conventional wisdom states that you choose the debt with the highest interest rate and pay down that one first. This makes sense from a purely mathematical and financial planning perspective. Paying down the debt with the highest interest rate first is going to cost you the least amount of money in the long term – if you stick with your repayment plan.

The problem is that people are not purely mathematical. We are emotional creatures who need motivation at a deeper level than our heads. Have you ever had trouble doing something that made sense logically because you just didn’t feel like it? Me, too. Motivation is key.

So, how can we stay motivated? A quick victory can help with this. If you can eliminate one credit card quickly, then you may feel like you’re actually getting somewhere for all your hard work and be encouraged to keep going. If we use this line of thinking, that would mean choosing the smallest debt and repaying that one first.

At this point, I’d like you to step back and think about what you think will motivate you the most – knowing all the money that you’re saving in interest or getting rid of one of your debts? If interest savings will light the fire for you, start with the debt with the highest interest rate. If having one less creditor is going to get a victory dance out of you, then choose the smallest debt. Either way, the important thing is to stick with your plan.

Here’s how this process would look with the example that we started with last week. The hypothetical debt list we used was this:

Card/loan Balance Minimum payment Interest rate
Credit card $3,834.79 $38.00 19.99%
Used car loan $1,772.29 $126.00   9.6%
Credit line $15,264.36 Interest only – $38.16 this month Prime + 3% (currently 6%)
Student loan $12,360.00 $134.14 Prime + 2.5% (currently 5.5%)
Department store credit card $2,500.00 $85.42 28.8%

The minimum monthly payments on these amounts total $421.72. Let’s say the usual monthly payments being made on the debts right now total $500. If we choose the highest interest rate debt to pay back first, the repayments would look like this:

Card/loan Balance Payment made Interest rate
Credit card $3,834.79 $38.00 19.99%
Used car loan $1,772.29 $126.00   9.6%
Credit line $15,264.36 $38.16 Prime + 3% (currently 6%)
Student loan $12,360.00 $134.14 Prime + 2.5% (currently 5.5%)
Department store credit card $2,500.00 $163.70 28.8%
Total monthly payment $500

Under this scenario, the used car loan would be repaid in about 15 months. At that time, the $126 could be added to the department store credit card payback making that balance disappear about 3 months later.

Alternatively, if the smallest debt balance is chosen to be paid back first, the payments would look like this:

Card/loan Balance Payment made Interest rate
Credit card $3,834.79 $38.00 19.99%
Used car loan $1,772.29 $204.28   9.6%
Credit line $15,264.36 $38.16 Prime + 3% (currently 6%)
Student loan $12,360.00 $134.14 Prime + 2.5% (currently 5.5%)
Department store credit card $2,500.00 $85.42 28.8%
Total monthly payment $500

Under this scenario, the used car loan would be gone in about 9 months. The $204.28 would be added to the department store credit card payment, erasing that balance about 9 months later.

Under both scenarios, it takes about 18 months to pay off the first two debts.

What if I can only make the minimum payments and I don’t have any extra

If you’re reading this wondering where all this extra is supposed to come from, don’t give up. For now, make your minimum payments. Next week, we’re going to address the idea of how to make this process go faster. If you aren’t able to make even the minimum payments on your debt, then you need to take radical measures right away. If you haven’t done so already, cut all your discretionary spending immediately. Getting rid of your TV bill may be enough to cover the minimum payments on more than one credit card. Brown bagging your peanut butter & jam sandwich instead of eating out at lunch may be enough to cover a few more. You probably need individual counselling. Try to get a recommendation from a friend, your church, or another trusted source.

What about a consolidation loan?

Consolidation loans seemed to be in vogue years ago and have now fallen out of favour. It seems that many people who added to their mortgage to pay off their credit cards just racked up their credit cards again and ended up with high credit card debt AND a higher mortgage to pay. Having a second mortgage on your home can sometimes have other hidden costs such as higher house insurance premiums or mortgage insurance premiums. Taking out a second mortgage to repay credit card debt is just not a good idea.

However, sometimes shuffling existing debt around without any new borrowing can be beneficial. For instance, in our example above, if the department store credit card loan could be transferred to the credit line, I would give that the thumbs up IF the department store credit card is then cancelled immediately after being paid off. Getting professional advice for any type of debt reshuffling would be a good idea.

Your assignment for this week

Rank your debts in the order you plan to pay them back. Choose either the smallest debt first or the one with the highest interest rate. Make your minimum payments on all debts and then put all the extra allocation to the first debt.

I’d love to hear which order you chose – did you choose the highest interest rate, the smallest debt, or make a different choice altogether? Please let me know in the comments.

Coming up next week… C is for cut

September 30, 2012

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