Debt: Organizing Your Pathway Out

Debt gets a bad reputation but is a critical part of our financial lives today. Without debt, many of us could not purchase homes, cars, attend college or have some emergency cash to help pay the bills each month. In small doses, debt can be a beneficial means to an end. Overindulge in debt, however, and it can lead to financial ruin.

When you are thinking about taking on a debt obligation (like a car loan), your first step should be to revisit your budget. How much money do you have available to spend on debt payments each month? This number should be your primary guide driving your purchase price. Sometimes, however, you will have situations, like student loans, where you might have reason to be more optimistic about your earning power in the future and can afford to take on more debt now.

Once you have made the decision to proceed with a debt obligation, make sure you research to find the best interest rates, especially online. Many people don’t know to do this and only visit the source they are most familiar with (the car dealership, the local bank, the college student loan office). I used to do the same thing in the past but now I would never take on any debt without trying to get the lowest interest rate by investigating competitors. It is often helpful to make a spreadsheet or table of the name of the lender, the interest rate and the fees charged. Google is your friend here as well as sites like bankrate.com. Also, asking friends and family for recommendations has yielded a lot of great tips as well.

Finally, once your loan is secured, you are in the “fun” stage of paying off your loan. The first years of paying off a loan are the hardest. You feel the pain to your budget of the new obligation and even though you are dutifully sending in your hard-earned payments each month, it seems like they are hardly making a dent in your total obligation. It is a bit depressing, actually. Once you get a few years in, however, you start to get used to planning for the debt expense, the bill-paying goes on auto-pilot and one day you notice that your outstanding balance is actually going down! Toward the end of the debt payoff, you take pride in writing the last few checks knowing that soon you will be debt free and will have more money back in your budget each month. The last check is a celebration!

The above scenario applies best to one-time obligations like student loans and mortgages. Many people never get to a “final payoff” amount because their debt is “revolving” credit like credit card loans. So, while they are paying off their current balance, they are also adding new charges on. It doesn’t take a mathematical genius to understand that you can’t get out of debt if you are spending more than you are paying. This is why you often hear financial experts advise to “cut up your credit cards.” The credit cards themselves are not evil but when you lack the discipline to spend only within your budget, they are an easy temptation.

The theme of this post is organizing your debt and by this, I mean a couple of things. First, you need to do the research described above to make sure you are taking on an obligation you can pay off and that you are paying the minimum amount of interest and fees that you have to. Second, you should understand the basic math that goes into loan payoff calculations and use these tools to organize your way out of debt.

The basic idea of a loan is that you take out a certain amount today from a lender and you pay the lender back the initial amount (principal) plus more (interest) to compensate the lender for the loss of use of the lender’s funds and/or the risk that you won’t pay the lender back. You pay the most interest in the first years of the loan (which is why your balance seems to never go down) and then over time you pay less and less interest until the loan is paid off.

Loans involve compound interest which gets confusing quickly to a lot of people. We have ventured beyond basic adding and subtracting and into multiplication and even calculus in some cases. Some people are so afraid of the complexity that they simply refuse to take out loans of any kind (which is OK but it can significantly limit your opportunities). Fortunately, there are many online calculators available that help you with the math. Below are two of my favorites:

1. The minimum payment calculator at bankrate.com. This calculator tells you “the true cost of paying the minimum” on a credit card obligation.

If we plug in the Median’s credit card balance of $3,000 at 18% interest into this calculator, we see that at their current rate of $150 per month, it will take them about 2 years to pay off their credit card balance (assuming they stop any new charges). If they only paid the minimum payment required on the card ($75), it would take them 18.5 years! Below is an example of an amortization table, showing how each of the Median’s monthly $150 credit card payments is applied with respect to interest and principal. You will note that the Medians pay the most interest in month 1 and the least interest in month 24.

Month	Fixed Payment	Interest Paid	Principal Paid	Remaining Balance
1	$150.00	$45.00	$105.00	$2895.00
2	$150.00	$43.43	$106.58	$2788.43
3	$150.00	$41.83	$108.17	$2680.25
4	$150.00	$40.20	$109.80	$2570.46
5	$150.00	$38.56	$111.44	$2459.01
6	$150.00	$36.89	$113.11	$2345.90
7	$150.00	$35.19	$114.81	$2231.09
8	$150.00	$33.47	$116.53	$2114.55
9	$150.00	$31.72	$118.28	$1996.27
10	$150.00	$29.94	$120.06	$1876.21
11	$150.00	$28.14	$121.86	$1754.36
12	$150.00	$26.32	$123.68	$1630.67
13	$150.00	$24.46	$125.54	$1505.13
14	$150.00	$22.58	$127.42	$1377.71
15	$150.00	$20.67	$129.33	$1248.38
16	$150.00	$18.73	$131.27	$1117.10
17	$150.00	$16.76	$133.24	$983.86
18	$150.00	$14.76	$135.24	$848.62
19	$150.00	$12.73	$137.27	$711.34
20	$150.00	$10.67	$139.33	$572.01
21	$150.00	$8.58	$141.42	$430.60
22	$150.00	$6.46	$143.54	$287.05
23	$150.00	$4.31	$145.69	$141.36
24	$143.48	$2.12	$141.36	$0.00

2.  The Debt Pay Down Calculator at bankrate.com. This calculator gives you a plan to pay off all of your debts and become debt free. In the Median’s case, we have the following:

$10,000 @ 8% for 5 years = $202.76 monthly (car loan)
$6300 @ 7% for 5 years = $124.75 monthly (student loans)
$3,000 @ 18% interest = $150 monthly (credit card)
$5,000 @ 0% interest = $100 monthly (amount to pay themselves to build an emergency fund)

The calculator asks how much “extra money” the Medians can squeeze out of their budget to help pay down their debts. We’ll assume they will give up cable TV to save $60 a month, they will cut down to just one vacation a year to save $62.50 a month on travel costs, they will cut down their clothing budget by $50 a month, and they will cut down their grocery bill to the “low cost” plan to save $200 a month. They will pay $100 per month into a savings account to start building their emergency fund.That gives us $272.50 “extra.” We will assume the Medians get no raises and no windfalls and that they are in the 25% tax bracket.

The calculator tells us that the Medians can be completely debt free (except for their mortgage) in just 35 months, including having built up $5,000 in emergency savings, if they stick to this plan. The plan that is generated tells the Medians to put all of their $272.50 extra per month to their credit card in order to pay it off by January 2011. They then put the extra toward their car loan and pay it off by May 2012. Then the money goes toward their student loans, which are paid off by November 2012 and then finally to their emergency savings account which is built up to $5,000 by February 2013.

You can play around with the calculator and see the effects of various decisions. If the Medians, for example, did nothing other than just commit not to charge one penny more to their credit cards, they would pay off everything in 59 months (5 years or 2015). If the Medians agree just to give up cable and put the cable payment of $60 toward their debt (along with not charging one penny more), they shave 9 months off the total payoff time.

Let’s assume the Medians look at this plan and agree that they want to be debt free by 2013. They also look at their budget and realize that all those extra charges they put on their credit card each month have to go, so not only do they have to make the cuts to the cable, travel, clothing and grocery budgets, they are going to try to cut down on their auto expenses by carpooling to work at least a few days to save on gas. They know that some months they will be less than perfect and they will borrow from their own emergency savings to tide them over but they are going to really try.

If they make it, the great news is that come 2013, the Medians have an extra $850 per month in their budget. If they are smart, they will treat themselves to a few things but plow most of this amount into retirement savings, college savings or adding to the emergency fund.

Being organized with your money is something I feel strongly about. A lot of people with serious debt problems never run these calculations– most because they don’t know how. As you can see, however, you can learn to organize your own finances. If you know someone struggling with debt, I encourage you to forward a link to this post to help encourage more people to learn to be smart borrowers.

Back on Wednesday when we will discuss more about borrowing and loans in the context of mortgages.