Start your debt management and reduction plan by first understanding your current situation. You need to get your financial records organized and start a budget. This debt reduction plan will obviously be a core component to your budget. If you have not done this already, you can find helpful information at http://www.personalfinancesage.com/.
How much Debt Can You Afford?
Many lenders and financial advisors cite common ratios such as the front-end ratio and back-end ratio in determining a healthy level of debt exposure for your personal financial situation. While these are generally helpful tools, they do not replace the simple fact of how much income you receive compared to how much you spend keeping in mind how much you need to save in order to achieve your goals. The best way to be specific about these items is to prepare and review your budget or similar cash flow statement. In any event, because the front-end and back-end ratios are commonly cited in obtaining loans, a brief explanation of each is provided here:
Front-end ratio: The front-end ratio is your total monthly housing cost divided by your gross monthly income. This total housing cost includes the principal, interest, taxes, and insurance related to the monthly payment of the housing. The “rule of thumb” is that your monthly front-end ratio should not exceed 28 percent.
Back-end ratio: The back-end ratio is your total monthly housing costs as defined above plus all of your other monthly debts. Other monthly debts include auto loans, credit card payments, personal loans, student loans, and other personal debt. The “rule of thumb” with the back-end ratio is that it should not exceed 36 percent.
The theory with these ratios is that up to 36 percent of your gross monthly income will be made up of housing costs and debt payments, another 25 to 30 percent of your gross monthly income will be allocated to income and Social Security taxes, leaving the remaining amount to use for household expenses and savings.
What are your debt ratios? See the table below to input your own information:
PERSONAL DEBT RATIO CALCULATIONS
Front-end Ratio – 28% guideline:
Total monthly housing expenses * $____________
Divided by
Total monthly gross income $____________
Result ____________%
Back-end Ratio – 36% guideline:
Total monthly housing expenses * $____________
Add monthly debt payments ** $____________
Total combined monthly payments $____________
Divided by
Total monthly gross income $____________
Result _____________%
* figure should include monthly principal, interest, taxes and insurance
** figure should include auto loans, credit card payments, personal loans, and student loans
One nuance to this type of evaluation is not taking into consideration your particular savings goals. For instance, if you are closer to retirement and have not saved enough money for this purpose, you may need to increase your monthly savings. Given this added monthly savings allocation the standard front-end/back-end guidelines may not be a complete enough analysis of your debt position. Again, you should refer to your budget for specific details on your particular loan affordability. In another situation, you may be young, borrowing well within the guidelines given above, and saving on a regular basis in an amount that will satisfy your financial goals. In this scenario, the ratio guidelines are helpful and appropriate. The point here is that these ratios are guidelines and not specific conclusions as to whether or not you should take on a loan or whether or not your current debt levels are appropriate for your situation. If you complete the table above and find that you are already in breach of the guidelines, you should pay particular attention to the next section on Debt Reduction.
Debt Reduction Plan:
Many people have too much debt. Reasons can vary from the loss of a job, unexpected expense, divorce, medical condition, loss of family member, or simply living a life of unhealthy and excessive spending habits. If you have too much debt, you may fall into one of these categories. The good news is that for most people, there is a solution. It will require understanding of your situation, development of a plan, and action. And the action may not be easy. As you go through the process, the act of doing something about your situation will hopefully provide you with some relief from anxiety.
Let’s start the process. First create a debt schedule by listing all of your debt by name, interest rate, minimum monthly payment amount, past due amount, and total amount due. Include all credit card debt, personal loans, medical loans, student loans, home equity lines of credit (but not your primary mortgage loan) and any other personal debt. Be sure to keep in mind the amount of early termination feesthat may be owed by termination or paying off the debt early. Second, arrange the debt in the order of highest interest rate first. Then input the amount of money you have available to make such debt payments each month from your budget. The surplus or deficit will let you know what action you need to take at this point.
Complete your schedule and totald up the columns. If you have money leftover each month then that is the money you can use for other purposes such as savings. If you have a deficit, you need to start developing a plan to reduce your debt. Here are some things you should consider in reducing your debt:
Past Due Payments: In order to preserve your credit status, you should tackle any past due payments first. The negative effects of late payments include lower credit scores, higher interest rates, and expensive late fees. Once you are up to date with all of your credit cards and loans you can move on to devising a strategy for selecting which debts to pay next.
Eliminate Payday Loans: If you are in the payday loan trap, get out of it. The interest on those loans is extremely high and until you stop relying on these advances, you will have difficulty in repaying your other debts.
Which Loans to Pay Down First: Once you are current on all of your debts, target the high interest bearing credit cards and loans. Make an additional payment on the credit card or loan with the highest interest rate in order to pay it off first. When you have completely repaid this loan, move to the next highest interest rate bearing loan, and so on.
CAUTION: Remember to pay at least the minimum monthly payment due on all of your loans and keep them current. You will not do yourself any good by aggressively paying down the high rate loans while avoiding payment on others. This will negatively affect your credit.
You may want to consider other factors in deciding which loans to pay off first other than high interest. For instance, if you are more concerned with your credit score, you may want to target credit cards that are at the maximum limit. A high debt balance compared to the credit limit can hurt your credit score. A rule of thumb is to keep your credit card balances at less than 30 percent of the total available credit amount.
Use your Savings to Repay Debt: If you have $100.00 in a savings account earning you 5% per year (about 3% after tax) and a $100.00 credit card balance with an 18% interest rate per year, you would be smart to pull the money out of savings and pay off the credit card balance. This is the general theme in using savings to repay debt.
Exceptions: There are of course exceptions to this thought.
1. First of all, if you don’t have an emergency savings fund (usually three to six months worth of income) you should keep your debts current and build this emergency savings. Make this your highest priority.
2. Another exception is investing for retirement through a company sponsored retirement account. Because company sponsored retirement plans can offer matching amounts up to certain limits, your ultimate return on your investment will likely be more by investing in this type of plan. If you invest $100.00 in such a retirement plan and your employer has a 50% matching plan you have already made $50.00 on your investment.
3. If your savings is held in a certificate of deposit (CD) or other investment where a termination penalty fee is due for early withdrawal, you won’t get the same interest advantage. If on the other hand you are behind on your monthly debt payments, paying an early withdrawal penalty may be worth saving your credit rating.
Other Ways To Get Help:
1. Apply for a lower interest rate credit card and transfer higher interest balances. One resource to search the market for available credit card deals is CardWeb.com (http://www.cardweb.com/). Don’t forget to cancel and cut up the high interest credit card once you have paid it off!
2. Contact the high interest rate credit card or loan provider and try to negotiate a lower rate. If you let them know they risk losing you as a customer and that you are shopping around for a more favorable credit card, they may give you a better rate. Keep in mind that credit card companies make money from merchants where you use your cards in addition to your interest payments.
3. Contact your credit card bank or other lender and talk with them about alternative payment arrangements. You may think that this is a hopeless cause, but it is not. If you are at a point of being late or skipping payments, you owe it to yourself to at least try it. If you are successful in getting some relief be sure to follow up on your promise to pay under the alternative payment plan. Not doing so will almost assure you of future problems with your lender.
Credit Counseling Agencies:
With the increase of people in need of help with debt restructuring, many are turning to credit counseling agencies. These agencies promise debt relief and avoidance of bankruptcy. Some agencies may deliver these results, but many others do not. Complaints of these agencies include the inability to deliver on the promise of debt restructuring resulting in tarnished credit ratings.
Many credit counseling agencies offer debt management programs where they negotiate monthly payment plans with your creditors and collect a monthly fee from you for handling the payments. The problem with this scenario is that the agency makes money on you only if you are in their debt management program. This isn’t much incentive for them to help you out of debt. You should strongly consider avoiding these types of programs.
The conclusion that can be drawn from this should not be to avoid these types of agencies altogether but to use caution when selecting a firm. Here are some questions to consider:
- How long have you been in business?
- How long have you been working for the agency? The longevity should be a strong factor in considering which one to choose.
- What are your specific qualifications? Remember to work with an individual and not a group. In doing this you will want to know the qualifications of the person you are dealing with. If you are talking to a sales person, move past them and evaluate the credit counselor.
- Client references – ask for references of the counselor and call them. You want to establish the quality of the counselor you will be dealing with and not just the agency.
- What are your fees and costs? Get this in writing and be sure not to gloss over the fine print. You should also get a blank copy of any agreements you will be asked to sign and review them.
- What licensing is required in your area?
- Are you (credit counselor) in compliance with the requirements?
- How are you (credit counselor) paid? Make sure there is no conflict of interest in the way they are paid such as with debt management programs.
- What is your privacy policy? Understand any information sharing that they may practice.
Some helpful resources in finding credit counseling agencies can be found at the National Foundation for Credit Counseling website at http://www.nfcc.org/. Anther helpful site is the Federal Trade Commission’s website at http://www.ftc.gov/.
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