How to Deal With Debt
For many of us, some form of debt is a fact of life, but in my view it’s something we should use for our advantage rather than against us.
Carrying a lot of consumer debt such as credit cards and loans acts like an anchor dragging behind us or trying to drive with the handbrake on.
Not that I am demonising all kinds of debt, far from it. How difficult would buying a house be without a mortgage or many of the functions of modern life without some kind of credit option?
My purpose here is to encourage you to pause for a moment and think about how much debt you have and how quickly you can pay it off.
If you have credit cards do you pay off the full balance very month? If so great, if not you are certainly not alone. The average credit card debt in the UK is almost £2000.
Do you remember opening a credit card account? Whether online or over the phone, you were most likely given the option to make you monthly payments by direct debit. Which is a good thing, so you don’t forget the payment and incur fees plus damage to your credit score.
But here’s the thing, the credit card companies usually give you the option to pay the full balance or a minimum percentage such as 2 or 3%. This is a sneaky trick which costs you more in interest and takes years to pay off the debt. Think about it for a moment, how do the credit card companies make money? Largely by charging you and I interest on our outstanding balances right. So, it’s in their interest (excuse the pun) to keep you paying the debt for as long as possible.
I made a video which explains saving money on credit cards in more detail
As an example, if you had £2000 outstanding on your credit card at a 20% APR, a minimum 2% payment would be equivalent to £40 a month.
If your direct debit was set up for this £40 fixed payment it would take 7 years 11 months to clear the debt and a total interest cost of £1,818.
But if you just left it alone and paid the 2% as a direct debit it would take, wait for it, 42 years to clear the debt at a total cost of £5,588!
I don’t know about you but that makes me angry and is one of the reasons I am so passionate about financial education to stop people being ripped off like this.
Find a Lower APR
Once you have ensured you are paying a fixed amount, rather than a percentage the next step is looking at the cost of interest or APR and if you can switch to a cheaper provider.
In these days of low interest rates, there is no need to be paying 20 or 30% interest on your credit cards. Use a comparison site to see if you can switch outstanding balances to a lower rate card or take advantage of a zero percent offer.
Of the money you pay every month, the vast majority goes towards the interest and very little is taken of what is called the principal, or amount you owe. So basically, you are running to stand still.
With a zero rate card, the payments are all going towards paying off the principal, which is why the debt can be cleared faster.
What about debt consolidation loans? Good question. If you have several credit cards at say 20% interest and could clear them with a loan at for example 10% that would make sense, right? Well, maybe, it depends on how long you take the loan out for. Its tempting to go for a longer term perhaps 5 years or more and thereby reduce your monthly outgoings. But remember to look at the total cost of borrowing, which should be provided.
It’s nice to reduce the amount you are paying every month, particularly if money is a bit tight at the moment. But it can be a false economy if you end up paying more in interest in the long term.
Plus if you do go down this route, once you clear your credit cards don’t be tempted to start spending on them again. Hide them in a drawer for emergencies or close one or two if you have several. Keeping your credit utilisation rate low improves your credit score. So as tempting as it might be to ceremoniously cut them up, keeping a credit card with no or low balance can be a good thing.
Having a Plan
The third way I am going to suggest you deal with debt is by creating a plan for overpaying your credit cards and loans but in a systematic way.
In my courses and live events, I teach a system called the snowball effect.
To start write down the outstanding balances on all your credit cards and loans. You may wish to use a simple spreadsheet or a pen and paper.
Then write down the interest rate and minimum monthly payment for each one.
Next rank them in order of the outstanding balance, with the lowest at the top.
Each month you commit to overpaying that amount by as much as you can. Maybe you can earn a little extra from working overtime, a second job or a side hustle business. Maybe you can also trim your expenses elsewhere.
Imagine that the minimum payment was £40 as in our earlier example and you could find an extra £50 per month and you directed the combined £90 at the first balance. All the extra payments are taken off the principal because your regular payment is covering the interest.
After a few months that debt has gone. You now have a ‘spare’ £90 per month which you use to target the next lowest balance. Now that card will be cleared in a much shorter time and you can roll the mount you were paying there onto your next debt.
It also works for loans and even your mortgage, if your provider will allow a degree of over payment.
Lots of information here so let’s recap.
- Start by getting clear about how much you owe, and the minimum payments needed for each card or loan.
- Then look to switch to zero or low-rate cards if you can.
- Ake sure you are paying a minimum amount as a fixed sum rather than a percentage.
- Finally use the snowball effect to create a plan and stick with it. You will see the debts dissolve in record time.
It takes a little time and discipline but as Jim Rohn so eloquently said, the pain of discipline is always less than the pain of regret.
If you would like some help or coaching through this, debt management forms part of my Financial Liberation programme, which is a 6-week live online course. Details are in the show notes or visit our website at fearlessfinance.co.
If you found this post useful you may enjoy the Fearless Finance Podcast.
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