CFO of Life #20 - Debt Solutions: How to Get Out of the Hole and Stay Out

"Some debts are fun when you are acquiring them, but none are fun when you set about retiring them." – Ogden Nash

Debt is like a trap, once you get caught, it is hard to get out. Still, not all is lost, but it would take time, patience and dedication.?

And as everything to do with money, it is hard to talk about it. It is not something we are taught to talk about, but this should change.?

I have seen how people close to me struggle with debt. It haunted them for years. But what scares me more than that is the current debt situation in the world.?

We are seeing new highs of credit card debt. People are having record-breaking amounts of student loans. Governments are defaulting on their debt. And simultaneously, inflation and interest rates are higher than ever.

It worries me, as there must be many who take bad loans and suffer the consequences. They will have to bear the weight for a long time, but all is not lost. This week, I will show you the ways a family member and I worked on handling their debt. But before that, let's get through the basics.

What are the elements of debt?

There are four components to debt. They are quite straightforward, but it is good to make sure that we all start from the beginning and build up.

*Principle – The total amount you take out, ie. the money you receive

*Interest rate/ APR – The percentage of interest charged on a monthly/ yearly basis

*Payment – Your monthly payment amount

*Total cost – The total amount you repay for the loan

*Duration – The period of time you have to repay the loan

What makes it tricky to get out of debt?

Well, most of us fall into debt at the lowest points of our life. It is usually caused by something that goes bad. Either a death in the family, loss of a job, divorce or just bad circumstances.

It is hard to get rid of debt, but there is always light at the end of the tunnel. It will surely take some work and dedication to a plan, but debt is something you can eventually conquer.

Why is it hard to get out of the debt trap?

In general, we get into debt when we purchase things we can't afford, which then spirals into substantially bigger payments than what we can afford to make. Craving bigger and better things is normal human behaviour and could be classed as an internal driver for purchasing. That is usually the case with big cars or expensive real estate. However, there are a lot more unexpected external factors that can come into play here.

The most obvious external reason for debt is a change in interest rates. This usually makes a huge mess for those whose debts have a floating interest rate. It will also make all new loans a lot more expensive. So a lot of people would fall into the trap of taking an extremely unfavourable loan.

This is a problem as it can easily make your monthly payment skyrocket. And as a second level of impact, it can easily push your debt-to-earnings ratio to levels that the bank is not comfortable with. Which can result in a foreclosure or a vehicle repossession.

At the same time, with all the layoffs that are happening, I can't fail to mention the loss of pay. A lot of people start struggling with debt shortly after a sizable reduction or a total loss of their salary. But having a properly sized emergency fund can help eliminate this type of pressure.

Now that you have debt, how can you repay it?

Take a deep relaxing breath and let's make a plan. Depending on your situation, there is a different approach you can take.

I will present three strategies. Use them as appropriate to your situation. One of them is for short-term loans, whereas the other two are more suitable for a longer time period. Let's start with the short-term strategy and gradually move to the more complex ones.

Credit consolidation:

This concept is to unite all of your loans into one bigger loan. That way you can lower your APR and buy yourself some extra time. Additionally, in some countries, you can use a credit card with a limited or zero APR for a fixed period of time. That way, you can consolidate your small loans and take a “breather” to catch up with the loans.

But, if you can’t get a card to unify your loans, you can always talk with your bank and try to bunch them up as one product. That would be an ideal situation. However, remember that this is sometimes tricky and might not work for you. Because if your credit score is already low, you will have a hard time convincing any lender to give you money.

Avalanche:

This approach is really simple, cover the minimum on all and pay as much as you can towards the highest APR loan. That would result in you not incurring any penalties, as you pay all minimum fees. Meanwhile, you will be reducing the maximum interest that you can accrue.

Here is the step-by-step guide on how to do it:

Step 1: List all of your loans from the one with the highest APY towards the one with the lowest APR

Credit Card - 53%

Payday loan - 17%

Auto loan - 5%

Student loan - 3.75%

Mortgage - 3%

Step 2: Set up an automated monthly repayment for the minimum amount on all loans

Step 3: Set up an additional automated monthly payment to the loan with the highest APR

• The more money you allocate towards this, the quicker you will take care of all the loans

Step 4: Once the highest APR loan is paid, review if there are any changes to the APR of all other loans then rinse and repeat Step 2 and Step 3

Taking this approach will minimise the amount of extra interest that you have to pay.

Snowball:

This approach is somehow similar to the avalanche. Instead of focusing on the maximum APR, it focuses on paying off debt from the smallest to the biggest debt. The rationale is that closing the smaller loan will prevent the accumulation of any interest with it. Furthermore, once you close one loan, you will have more money to contribute towards the next loan. Which is where the name “Snowball” comes from.

Here is the game plan for how to approach this:

Step 1: List all of your loans from the one with the lowest total dollar value to the one with the highest value

Overdraft on your debit card - $200

Payday loan - $600

Auto loan - $3 000

Credit card - $6 000

Student loan - $50 000

Mortgage - $250 000

Step 2: Set up automated monthly repayments for the minimum amount on all loans

Step 3: Set up an additional automated monthly payment for the smallest loan

• The quicker you pay this off, the quicker you will take care of all your loans

Step 4: When you pay the smallest loan off, review all the rest and create a new ranking

Step 5: Repeat step 2 and step 3 until you pay off all of your debts

Still, there is a point in time, when this approach is no longer the most optimal solution. That point is when you clear most small loans, and you are left with the larger loans. At that point, you can move to the opposite approach and start paying off the biggest loan. But that overlaps with next week article about mortgages and when and how to take them.

Regardless of which approach you take, remember that many people can and do manage to get out of mountains of debt. But it is all a matter of time, picking the best strategy and getting stuck into the problem. Just remember, debt is a tool, so learn how to use it and make the best out of it.

Next week: Buy or Rent? Why and when is it actually worth buying a house?

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Post #20 in the series CFO of Life?#si ?#personalfinance ?#CFOofLife