Five Steps To A Debt-Free Life
Debt consolidation is a very useful tool in every budgeter's tool belt. It can lift heavy debt loads off your shoulders, open doors to financial freedom and shine a light on an otherwise darkened future plan. In this article, we'll show you five easy steps to renovate your debt load with this multifaceted tool.
Getting Out of the Red
Consolidation is one way to rid yourself of your debts quickly by combining all your current outstanding loans and liabilities - and their generally outrageous interest rates - into a single debt vehicle with a lower interest rate. Instead of having to pay a number of different lenders each pay period, you take out a new loan to pay off all of the other liabilities and are left with only one, lower interest loan to service, allowing you to pay down your debt more quickly.
According to Gail Vaz-Oxlade, the personal finance guru behind TV's "'Til Debt Do Us Part", consolidation is a way to save "bags of money".
"Consolidation is important because people are often paying too much interest on their debt," Vaz-Oxlade says. It's also important for people who don't know, or can't seem to manage to pay their bills on time, she adds.
During her many years of working with couples and their finances (on and off the show) Vaz-Oxlade says she has run into a lot of individuals who are too scared to open their statements and who are overwhelmed by multiple payment dates. A consolidation loan takes all the outstanding debts and payments and transfers them all into one loan with only one payment date to remember and one statement to read.
How It Works
Taking on debt to get rid of debt? How can this possibly help? Let's look at an example.
|Example - Consolidation Savings
Let's say that you currently have three credit cards that charge 28% interest annually, they are maxed out at $5,000 each and you're spending $250 a month on each card to pay them off. If you were to pay off each credit card separately, you would be spending $750/month for 28 months and you would end up paying a total of $5,441.73 in interest.
However, if you transfer the balances of those three cards into one consolidated loan at a more reasonable 12% interest rate and you continue to repay the loan with the same $750 a month, you'll pay one-third of the interest ($1,820.22), and you will be able to pay off your loan five months earlier. This amounts to a total savings of $7,371.52 ($3,750 for payments and $3,621.52 in interest).
|Loan Details||Credit Cards (3)||Consolidation Loan|
|Term||28 months||23 months|
|Principal||$15,000 ($5,000 * 3)||$15,000|
Remember, however, that consolidation only works if you don't pick up those three credit cards at the end of the day and start spending again. Consolidation is a tool to help you get out of the doghouse, not to get you a nicer and more expensive doghouse.
Should you consolidate?
First, let's take a look at your current debt load and spending habits to determine whether consolidation is right for you. Vaz-Oxlade offers a list of questions that demand you be honest with your finances and yourself.
|Quiz - Are you in a credit crisis?
If you answer "yes" to any of these questions, you could be headed into deep trouble.
Did you see yourself mirrored here? If so, don't fret. Consolidation just may be your key to financial freedom. Let's look at the five steps you need to take to consolidate your debt and pay it off.
5 Steps to Easy Consolidation
Step 1: Identify your debt load.
This is where you have to face those unopened statements and bills. You need to determine good debt from bad. For example, mortgage debt that is less than 25% of your gross income is considered good debt, whereas consumer debt is bad debt. Next, calculate total debt owed to family and creditors, identify which debt has the highest interest rates and find out how much you are actually paying in interest on those debts.
Step 2: Create your budget.
Decide how much you actually need for daily life, fun, savings and to service your debt repayments.
You will probably find out that you'll have to cut out some of the luxury items in your budget until you get your debt in order.
Step 3: Get your consolidation loan.
- How to Apply: Call and book an appointment with a financial advisor at your bank of choice. Often, you will get the best rates with the bank you have the most history with, or the one that holds your mortgage.
- Documents: Although each lender will probably require different documentation depending on your history, the most commonly required pieces of information include a letter of employment, two months' worth of statements for each credit card or loan you wish to pay off, and letters from creditors or repayment agencies.
- Equity vs. Debt: According to Vaz-Oxlade, "if you have debt and equity, you should refinance."
This means that you take your unsecured debt (from credit cards or personal loans) and put that debt into a secured debt structure (like your mortgage). Banks will often charge you less interest on a secured debt because if you default, the bank can get its money back (through the sale of your home or other assets.).
- Term: Vaz-Oxlade recommends that you take no longer than three years to pay off your debt to avoid debt fatigue.
Step 4: Pay off your debt.
This may be decided by your lender, who may choose which debt gets paid off first. If not, you should start by paying off your highest-interest debt first. If you have a lower-interest loan that is causing you more emotional and mental stress than the higher interest ones (like a personal loan that has stretched family relations), you may want to start with that one instead. If you aren't given the final say on which loans get paid off first, if something is important to you, you should still fight for it to be paid off in a timely manner.
Step 5: Stick to the plan.
Consolidation only works to free you from debt if you stop overspending once you pay off your cards. Once you pay off one set of debts, move the payments to the next set in a waterfall payment process until all of your bills are paid off. Once you are debt free, you can move those payments into savings or investments.
What to Do if You Aren't Approved for a Loan
If banks or lending institutions laughed you out of the office, or if they won't reduce their interest payments beyond your current amounts, there are some alternatives to help you get out of debt faster. Here are a few of Vaz-Oxlade's suggestions:
- Apply for a lower-interest credit card. Vaz-Oxlade chalks this alternative up to one of the great financial anomalies in the credit world.
A person who carries a balance every month (and, who is making the required payments) will have a higher credit score than those who pay off their bills at
the end of every month, which make those with unmanageable debt loads more able to access credit cards. The point here is to get a card with lower interest
and transfer the debt from the higher interest cards to the lower interest ones and then close the high-interest accounts.
But this step comes with a warning: You must cancel your other cards to prevent you from running them up again. You want to get out of the doghouse, not get a bigger and more expensive one.
- Reduce your debt load and reapply. If you can make the payments on your cards on your own already, try to up the amount for a month or two to show the bank that you are dedicated to eliminating your debt. If you can't manage to reduce the amount currently, get a second, third or better job, Vaz-Oxlade suggests. Your second job should be to service the debt, not to get you in worse trouble than before.
- Be your own advisor. A financial advisor will tell you to tackle your high-interest debt first while managing the payments on lower interest debt. If you do this on your own, you'll be miles ahead of reaching your goal on your own terms.
If you have tried the ideas above and still have not found an answer, there are a few more last-resort options:
- Family loans. If you go this route, write up a contract with your family including payment dates, when the loan will be paid off, and what the consequences will be if payments are missed (added interest, etc.).
- Dip into retirement savings or insurance plans. This option is less than ideal because you are essentially stealing from your future. However, if all else has failed, you might want to consider taking money out of these areas as long as you make a plan to repay it - and stick to it - in a short time frame. (To learn more, see Eight Reasons To Never Borrow From Your 401(k) and Should You Take A Loan From Your Plan?)
No Need to Hit Rock Bottom
You don't need to hit rock bottom before you can start to rebound from debt. Nipping your debt in the bud before you face emotional and financial bankruptcy is the best option, and consolidation is a tool to help you avoid bottoming out. If you can budget and save before you shop and spend, your foundation for a healthy financial life will be set.
by Rachel Humenny
Rachel Humenny is a freelance photojournalist and one of Investopedia's content editors. She and her husband currently run a photography company called Diamonds Photography, in Edmonton, Alberta, Canada.
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