Entrepreneurial Tip Corner: Managing Personal Debt
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Personal debt is simply a fact of life in today’s society. How we manage that debt can be the difference between fiscal freedom and hardship. Most of us have to borrow to finance essential expenditures on education, vehicles and housing. It’s a daunting reality that most of our monthly income is spent paying off our loans, however, there are ways to manage personal debt more effectively without resorting to drastic measures, such as declaring bankruptcy.
Here are 10 facts to help you manage personal debt:
- Americans are loaded with credit card debt. The average American household with at least one credit card has nearly $10,000 in credit card debt and the average interest rate runs in the mid- to high teens at any given time.
- Some debt is good. Borrowing for a home or college education usually makes good sense. Just make sure you don't borrow more than you can afford to pay back, and shop around for the best rates.
- Some debt is bad. Don’t use a credit card to pay for things you consume quickly, such as meals and vacations, if you can't afford to pay off your entire monthly bill in full in a month or two. There’s no faster way to fall into debt. Instead, put aside some cash each month for these items so you can pay the credit card bill in full. If there’s something you really want but it’s expensive, save for it over a period of weeks or months before charging it so that you can pay the balance when it’s due and avoid interest charges.
- Get a handle on your spending. Most people spend thousands of dollars without much thought to what they’re buying. Write down everything you spend for a month and cut back on non-essential things that you really don't need. Start saving that left over money or use it to reduce your debt more quickly. Think about your spending habits and make one small change at a time. Lots of small changes can lead to big savings over time.
- Consolidate and pay off your highest-rate debts first. The key to getting out of debt efficiently is to first pay down the balances of loans or credit cards that charge the most interest, while paying at least the minimum due on all your other debt. If you consolidate your loans and credit card debts, you will probably reduce your average interest rate on all of your debts. Once the high-interest debt is paid down, tackle the next highest, and so on.
- Don’t fall into the minimum trap. If you just pay the minimum due on credit-card bills, you’ll barely cover the interest you owe, to say nothing of the principal. It will take you years to pay off your balance and potentially you’ll end up spending thousands of dollars more than the original amount you charged.
- Watch how and where you borrow. Many people look for the “zero interest for 6 months” credit cards, which may seem like they are too good to be true. However, these cards typically have a “balance transfer fee”, which almost always has a minimum of $50 or $75 and is a percentage of the amount transferred, usually 3 to 4%. If you are borrowing for 6 months, this “zero interest” offer is actually costing you somewhere between 6 and 8% on an annualized basis. In addition, most of us don’t keep track of the date on which we need to “juggle” this debt to another zero interest card, which usually results in at least one month of exorbitant interest at rates up to 30%. Also, it may be convenient to borrow against your home or your 401(k) to pay off debt, but it can be dangerous. You could lose your home, or fall short of your investing goals at retirement.
- Expect the unexpected. Build a cash cushion worth three to six months of living expenses in case of an emergency. If you don’t have an emergency fund, a broken furnace or damaged car can seriously upset your finances.
- Don’t be so quick to pay down your mortgage. Don’t pour all of your cash into paying off a mortgage if you have other debt. Mortgages tend to have lower interest rates than other debt, and you may deduct the interest you pay on the first $1 million of a mortgage loan. If your mortgage has a high rate and you want to lower your monthly payments, consider refinancing. In the current marketplace, you may be able to take advantage of the new FHA mortgage guaranty program and refinance for a rate as low as 4% with little or no closing costs. You should “shop around” and not simply rely on your existing mortgage bank to “do the right thing”, as they are in business to make money from you.
- Get help as soon as you need it. If you have more debt than you can manage, get help before your debt breaks your back. There are reputable debt-counseling agencies that may be able to consolidate your debt and assist you in better managing your finances. They can help you create a long-term plan for you to get out and stay out of debt. Some non-profit groups also have free debt-counseling services available to the public.
The bottom line is: We should all learn to spend within our means and save for that rainy day.
–Michael Herz, CPA, MBA