When the early 1990s recession hit, only a few years after I started my real estate business, I had six figures of debt. I was personally liable for all of it. Needless to say, it weighed heavily on me. Recovering from the economic downturn was exacerbated by large payments on loans and lines of credit. I struggled for a year before realizing the conventional wisdom on getting out of debt was wrong.
Most debt-counselors recommend that either you consolidate your loans so you have just one payment to manage or start by paying off the one with the highest interest rate. Since people laboring under a heavy debt load often have to constantly juggle cash flow, both of these make getting out of debt more difficult.
If your highest interest rate loan is large, initial victory is pushed far down the road. You want a win early in your quest to freedom from debt to give you momentum.
Consider that there are two companion goals to getting out of debt. One is maintaining or repairing your credit score. Late payments and charge-offs fall off your record after seven years and a bankruptcy after 10 years. But, you may want to get a home loan sooner than these time limits. As well, your borrowing cost increases as your credit score drops. (I will discuss the other goal below.)
Here is how I did it:
- Make a list of your debts. I recommend using a spreadsheet in which you enter the lender, the amount of the debt, the interest rate, the current monthly payment, and the approximate number of months to payoff.
- Reorder the list. Rank your debts from the one with shortest payoff period to the longest. The exception is any large interest-free loan, which you should pay last.
- Work your plan. Pay off the debt with the shortest payoff period as quickly as possible even if you pay the minimum on the others. Once you have done so you have three choices for the money freed up.
- Set it aside to build an emergency fund so you won't have to borrow money if something unexpected happens.
- Add it to the payment on the next debt on your list so you can pay it off more quickly.
- Create a fund to use when negotiating a settlement of another debt.
Any of these are reasonable and depend upon your overall financial situation.
- Renegotiate where possible. Speak to your creditors. See if you can reduce the interest rate or get part of the loan waived in exchange for paying it off more quickly. Some lenders will agree to remove derogatory information in your credit file if you arrange a faster payoff plan. If you are in the military, check if the Servicemembers Civil Relief Act applies to you.
The other companion goal is avoiding a future debt crisis. Many advisors on this subject recommend shunning loans. I don't find this to be a reasonable policy. Rather create a debt usage policy. For example, I don't borrow money except to buy a large, hard asset, such as a car or a house. I do not carry any credit card balances.
I still remember the stress of being overloaded with debt. At times it was debilitating. The telephone became my enemy since I never knew when a creditor was calling to dun me. Now, I recognize that like most financial products debt is a useful tool when used judiciously.
Do you have a debt usage policy? What is it?
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