The real skinny on debt elimination

By BOB CUNNINGHAM

When it comes to strategies for accelerating the paying off of unsecured debt, I’ve seen a bunch of them.  Everything from straight-forward approaches based on math to “snowball” strategies that focus on the emotional gains that can be made by lower balances, depending on where you look.

So I figured it was time to clarify and summarize.

When we’re talking about debt elimination, we are referring primarily to unsecured debt.  Sure, a strategy for paying off all your bills, including your mortgage, has merit in the big scheme of things… but there is such a thing as “good debt.”  And in most cases, your mortgage qualifies as good debt.

When you have a large balance on a credit card, you’re at a distinct disadvantage because the rates, which can be as high at 27%, put you in the unenviable position of paying more in interest than you are towards the debt itself.  For instance, if you owe $2,000 on a credit card at 20% interest, the total interest for a year (assuming no added charges) would be $400.  That figure, divided by 12, would come out to about $33 per month in interest.

So assuming your credit card company requires a $50 minimum monthly payment, at the start of the aforementioned 12 months your payment would have $33 going to interest – pure profit for the credit card company – and only $17 toward reducing your debt.  So entering Month No. 2, your balance owed would not be $1,950 (after you paid $50 toward the $2,000 original balance) but instead would be $1,983.  If you were to attempt to pay off this account solely by making the minimum payment every month, you would need about 5 1/2 years and would fork over more than $3,300 for the right to borrow $2K – a 65% over-payment strictly because of interest.

Paying that way makes no sense, unless you prefer to grossly overpay for things, in which case I just put my 16-year-old Honda with 150K miles up for sale.  Fifteen grand, and it’s all yours.

No wonder Capital One can afford to pay Samuel L. Jackson and Jennifer Garner to hawk their cards.

Seriously, the need to pay off this debt is… well… serious.  So how best to do it?

If you have just one debt, say, the card balance just described above, you simply add every available extra dollar you can muster to that $50 payment – because every dollar you add will go directly toward the balance –  and pay the thing off much more quickly. Simple enough.

But what if you’re like most debt-challenged folks – with six different debts, ranging from a few hundred dollars to several thousand, each with unique APRs and minimum payments due.  What then?

Unlike many so-called finance experts, I will level with you and explain here that there is more than one responsible answer to this question.  But none are overly complicated.  And NONE require the help of a credit counseling service. You can do this completely on your own… trust me.  I’ve done it, long before I became the all-knowing wizard I am today (kidding, of course).

Here is the process, broken down into manageable steps:

1. List all your debts with the following information:  Creditor/phone number/account number, balance owed, minimum payment due, the day each month that the minimum payment is due, interest rate.

2. For any creditors who are charging you more than 12% interest, call their customer service departments and request a drop in your rate.  Explain that you have multiple debts, are making a concerted effort to reduce/eliminate your debt, and that their understanding and assistance would be appreciated. Point out (if it’s true) that you’ve made your payments on time and kept your account in good standing.  If the first rep you speak with indicates that he/she cannot help you, ask to speak to a supervisor.  If after speaking to management, you cannot get them to agree to a reduced rate, inform them that you will be transferring the balance to another card immediately and will never again use their card or services.  Be polite, but firm in letting them know that there is plenty of competition out there who will appreciate your business at a more competitive rate.  That often is the kicker to getting the company to agree to help.  And remember, even a 2% reduction in rate is better than nothing.  Don’t be greedy – just ask that they reduce it as much as possible. (some companies have been known to eliminate interest altogether for debtors in real trouble, but that is the exception rather than a rule).

3. Figure a year’s worth of interest on each debt by multiplying the balance owed and the interest rate.  Then take that figure and divide it into the minimum monthly payment amount.  Jot down the percentage you get. Why are we doing this?  Because we want to know which minimum payments give you the biggest bang for your buck each month, regardless of balance.

4. Now do some rankings – three lists, to be exact.  On List #1, rank your debts from lowest balances to highest.  On List #2, rank your debts from highest APR to lowest, and on List #3, rank the percentages you figured in No. 3 above in order from highest percentage going toward interest to lowest.

5. Now scan the three lists you just created.  Is there a creditor that appears to rank near the top on all three lists?  If so, that will be your first priority debt.  If it appears that two or more creditors are scattered among the top with no clear “winner,” you can either create a quick points system to rank them separately (only if you’re a numbers nut like me), or you can just continue reading here…

6. You now have a decision to make – how are you going to prioritize your debts, for the order you will focus on each one at the expense of the others. As I said early on, there is not just one answer here – because I like to incorporate the human element into this.  We are, after all, humans and not machines and we want realistic solutions.  If you are the type who needs positive reinforcement as often as possible, and truly enjoys the sense of accomplishment, go after the debt with the lowest balance first and use List #1 as your priority list. If you are mega-frugal and want to save as many pennies as well as dollars as possible, pick the debt with the highest APR first and use List #2.  I don’t recommend using List #3 exclusively – putting that together was just an extra tool for us.

7. Once you’ve decided on which list you will utilize, the remaining steps are these:  1) Add all extra funds to be dedicated toward debt elimination to the minimum payment on the first (priority) debt on your chosen list, and pay it ASAP.  Make the minimum required payment on all other debts ASAP (no later, obviously, than by the due date); 2) Do this each month until the priority debt is paid in full, then take the total payment amount you’ve been applying to the first debt and add it to the minimum payment on the second debt, and send that amount in to the second debt – the new priority debt – until it is paid off; 3) Continue taking the “snowballing” payment amount and adding to the minimum payment of the next debt on the list, until all your unsecured debt is history.

As you progress, the process rapidly accelerates as you dedicate the same amount of money monthly towards your total debt throughout.  DO NOT be tempted to decrease the payment amount at any time.

Nice!  Very cool accomplishment, that few folks achieve once they get in too deep.   You should treat yourself to an unscheduled nap in your favorite hammock.  WARNING!  Do NOT celebrate any part of this process by taking 14 friends out to a fancy dinner and putting the bill on one of your cards.  Think I’m joking?  You’d be surprised.

8. OK, last item is to put your cards where you will not be tempted to use them again. Do not destroy the cards, and do not cancel or close your accounts. Doing the latter hurts your credit rating, and eventually I want to show you how the savvy use of credit cards can add money to your assets column.  If you lack the discipline to avoid using them right after having paid them off, put them in a can with water and freeze the can.  That makes it a big hassle to access them, and improves your chances of thinking twice before making a purchase you will later regret.

Eventually, you will be thawing them out, but not for a little while yet.

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DISCLAIMER:  This post represents the author’s opinion only, sometimes based on and supported by cited numbers and sometimes not. In no way should any part or all of the content of this post be interpreted as official financial advice, nor does it represent an intention to solicit readers into a specific strategy or investment.  Profitability is NEVER guaranteed.  Invest at your own risk.