How To Repay Debt

Sometimes, getting out of debt is not always the problem. In fact, some people can do a great job of setting aside money (i.e. saving) and can manage to put tens of thousands of dollars aside in a very short period of time... however, they might have a spending problem that essentially nullifies their commendable savings abilities. What normally happens is after a period of aggressive savings, these great savers but poor spenders have to cash out their savings (or equity) to repay debt and start fresh.

People with this problem will identify with this: their ability to stay out of debt will last a few months, maybe a full year. And then they use their credit. Not just for a simple purchase that can easily be paid off, but for a larger purchase that sets in motion an unfortunate spree that slowly and gradually racks up the credit cards and puts their current and future savings at risk.

The most obvious example of this type of individual can be found in every country, but particularly in the United States where, prior to 2007, people would spend excessively and then rely on convenient mortgage refinancing to eliminate their debt year after year (or whatever period it turned out to be). This was fine until property equity stopped growing and actually began to depreciate. Even though these individuals were not “saving” in the traditional sense, their net worth and equity was indeed increasing with every mortgage payment. Unfortunately for these types of real-property savers, their spending outpaced the rate of growth in their real estate. Anyway...

One interesting technique that many people like this should use involves reducing the available credit on their credit cards and simultaneously maxing out their credit card limits. For example, if credit card spending is what gets most people in the problems they have, after paying out these cards “for the last time,” they should minimize their limits to $1,000 or $5,000 or some other low limit that can be repaid easily after one month if they get into another of their spending sprees. The lower the better.

What most people dislike about this technique is that puts their “emergency” reserves rather low. This is an unsubstantiated fear because their savings history suggests that within a short period, they will have saved enough of an emergency reserve on their own. And, in the unfortunate case that something does come up before they are able to beef up their savings, then their improved credit score will qualify them for financing such an emergency purchase or debt. They key? Financing such purchases on an instalment basis, not on a revolving basis.

So, for people who are good savers and poor spenders, reduce those credit card limits and max them out so that you cannot get into trouble or be tempted to spend unnecessarily.

With more and more people receiving foreclosure notices (one in every twenty-three in Nevada, the highest rate in the US), it makes sense that so many people are worried about how to repay debt. For people who are fortunate enough to have at least some income coming into the household, there are some clear options that will not only provide some (or full) debt relief, but will also allow them to remain in their home.

Although none of these options are considered ideal for many, they do provide those with the ability to make debt payments options that may become inevitable anyway.

Debt Settlement

Arguably the most popular option for people who run into high credit card debt, debt settlement provides an effective way to repay debt when the income has been reduced and bankruptcy is not an option that the borrower wants to pursue. With debt settlement, the lender (or credit card company) agrees to write off a portion of the debt and the borrower agrees to repay the balance. For many, this reduces the monthly debt load sufficiently enough to meet all other obligations.

Chapter 13 Bankruptcy

This "new" option provides debtors with the ability to repay debt that is secured only. This is like wiping the credit card and other unsecured loan slate clear and focussing solely on the mortgage and other secured loans, like a car loan or lease. The downfall here is that any missed payments could result in the lender forcing full chapter 7 bankruptcy on the borrower.

These two options provide people who are feeling the stress of higher foreclosure numbers and lower employment prospects with the potential to repay debt legitimately without having to worry about losing their essential assets -- the house and car(s). When the means exist to repay debt, these two options provide a simple way to stay ahead and in control.

A recent posting about debt management piqued quite a bit of curiosity among my readers. The comment responsible was one where I suggested that people put all income against debt and then borrow against the remaining equity to pay for living expenses. While this makes financial sense (and will soon make logical sense to many), it is a rather complicated strategy to implement.

Making Sense Of The Strategy

Unfortunately, I cannot claim any of the glory for this strategy -- it is quite common among high net worth clients. It involves using just one account that is tied into your property. In other words, a mortgage. More specifically, a revolving mortgage where you deposit 100% of all earnings against this mortgage.

Typically, this would be a home equity line a credit facility, or HELOC. Borrowers would then have all of their earnings applied against this HELOC and, when needed, borrow against it for groceries, bill payments (like utilities, etc.) and all other expenses that arise throughout the month.

Financial Benefits

Let's compare a traditional mortgage of $250,000 to a HELOC of the same amount. We will assume the same rate (although the 30-year fixed will be a bit higher). With a mortgage, the monthly payments of $1,454.01 reduce the mortgage to $221,268.88 after five years. That's the easy part.

The HELOC situation is a bit different. Assume that someone who pays $1,454.01 for a mortgage pay other monthly expenses in the amount $1,200. This person (or family) probably earns $36,000 in after-tax income. By putting all $3,000 of after-tax income against the HELOC and borrowing the remaining 1,2000 at the end of the month, the remaining balance at the end of five years is just $182,715.90.

Is It Magic?

No, it's not magic at all. The reason why some HELOC-specific lenders are able to appeal to those who want to repay debt quickly is that most people do not have the discipline to take their extra funds and apply them against their mortgage. Sad, but true.

As well, people who watch their mortgage balance closely have a psychological investment as well. By investing their full bi-weekly payment into a mortgage, people know that taking out that dreaded $1,200 will have a negative impact on their goal. So they more closely monitor their budget.

Can This Work For Me?

That depends on how serious you are about getting out of debt. If you hate debt and want out at all costs, then you can not only make this work, but you can make any debt management system work. Arguably, this strategy makes life a little easier for you.

Talk to your mortgage lender if this strategy is something you would like to explore a little more closely. Run your numbers, make sure it makes sense and that you can remain disciplined. And, I am sure, you quickly see the results of turning your debt into wealth!

It seems obvious that most people who have questions about how to turn their debt trouble around are looking at ways to increase and improve their wealth. Not surprisingly, eliminating debt allows people to start building wealth.

 

There are some very good reasons why people with debt trouble should avoid a system where they repay debt and simultaneously invest (or build wealth). Ultimately, people cannot build wealth properly when they are only doing it part-time. When they repay debt first, they are able to channel 100% of their funds, without worrying about losing value to high interest costs. This means they are able to invest quite a bit more over the course of time.

 

Anyway, these are the easiest ways to repay debt quickly and start turning that debt into wealth!

 

• Get rid of credit card debt trouble. There is no advantage to carrying a balance on a credit card. Not surprisingly, cards are what most people cite as the reason why they have debt trouble in the first place. Get rid of them and then use the money you previously used (e.g. if you repaid $300 per month religiously, use this same $300 month) to invest.
• When you borrow, make sure there is a tax incentive to do so. For example, mortgage interest can often be written off (if not entirely written off in some areas). The benefit here is that you are borrowing for “free” since the amount of interest paid will get kicked back to you as a tax credit or write-off. When the funds come back to you as a refund, invest this money instead of spending it.
• Accelerate your repayment by reducing expenses and increasing income. Most people try only to achieve one or the other. By increasing income and reducing expenses, borrowers can repay debt a lot quicker. Although there is no interim investment strategy, it allows debtors to investigate different investment options.
• Put all income against debt, then borrow to make ends meet. As a more advanced technique which, to explain how to use properly needs an article all on its own, this allows people to reduce their total interest costs over the course of any period by at least a couple of percentage points. If you are able to properly schedule an investment contribution later in the period, you might be able to have both a debt repayment schedule and investment system running concurrently, although this is not typically recommended. Ideally, the goal should be to repay debt entirely, then focus on investing exclusively.

These are just four of the many strategies every day people can use to turn debt into wealth. As noted above, however, it is usually much wiser to repay debt before starting to build wealth, but those of us who lack the patience and just cannot wait, there are some strategies that can be employed during the debt repayment process.