What is Debt?
Debt is an amount of money borrowed by you from another person or entity. Debt is used by businesses and individuals as a means of making substantial purchases that they could not afford without extra funding. Debt agreements give the borrower permission to borrow money under the condition that it is to be paid back later, usually with interest. Many Australians find it easy to get into debt and in some cases, it is just too easy. To begin getting out of debt, or reducing your debt, you must first commit to the process. Debt reduction will likely not occur without some difficult changes in attitude and lifestyle. Making debt reduction a priority is the first step in the process, a process which could take months if not years.
Steps To Debt Reduction
Following is a list of steps which can help you get your finances on track and reduce your debt.
Step 1 – Work Out How Much Do You Owe
Before you can begin planning you need to know where you’re starting from. In a spreadsheet (or written down), list all your debts, their outstanding balances, minimum repayments, and interest rates.
- Credit cards
- Store cards
- Personal loans
- Car loans
- Student loans
Once you know what you owe don’t despair. The next steps will deliver a plan for getting on top of your debt.
Example: Debt Worksheet
|DESCRIPTION||AMOUNT ($)||LENDER||OWNER||INTEREST TYPE||INTEREST RATE (%)||TERM REMAINING||REPAYMENT AMOUNT||REPAYMENT FREQUENCY||BREAK FEES|
|Credit Card 1||$8,000||ANZ||Husband||P&I||19.50%||30 years||$200||Monthly||No|
|Credit Card 2||$12,000||ANZ||Wife||P&I||18.72%||30 years||$300||Monthly||No|
|Personal Loan 1||$15,000||GE||Husband||P&I||13.24%||60 Months||$350||Monthly||Yes|
|Personal Loan 2||$5,000||WBC||Wife||P&I||10.80%||50 Months||$150||Monthly||No|
|Car Loan||$25,000||Toyota||Joint||P&I||8.50%||20 Months||$400||Monthly||Yes|
P&I = Principle and Interest, IO = Interest Only
Step 2 – Decide On Debt Reduction Strategy Which Suits You
Option 1 – High Interest Focus
A fundamental rule of paying off debt, is to focus on paying out the debt with the highest interest rate first. Make the minimum payment possible for every account, besides the one that you are trying to eliminate first. Then work yourself down the list from highest interest rate to lowest. Once you have paid off the highest interest rate debt, then move your money to paying off the second highest etc. Using this method from the above example you would focus on paying off Credit Card 1 first. This method helps you to pay less interest overall.
Option 2 – The Snowball Method
The Snowball Method involves paying off debt in order from smallest to largest, regardless of interest rates and fees, gaining momentum as each balance is paid off. When the smallest debt is paid off you then roll the money you were using to pay off that debt into the next smallest balance. So, if you have a small balance owing on a store card that is charging you the lowest interest rate, you would pay this off first before paying a debt where you might be charged a higher interest rate and a higher amount owing. With this method, you may end up paying more in interest but the sense of achievement that is gained from paying off the smaller debts can provide the motivation required to tackle the larger debts. This method can provide you with a sense of accomplishment.
The snowball method is more about behaviour modification. It prepares you for paying progressively bigger debts. When you focus on your first debt, you make the minimum repayments plus whatever else you can afford. Once you have wiped away this debt, you focus on the next debt and add whatever you were paying on your first debt to the minimum amount you’re paying on this debt. This is why it is called the snowball method, as with each debt you pay off, the amount you can contribute to paying off debt scales up.
Step 3 – Look at ways of minimising interest
Looking at reducing the interest rates of your credit cards and mortgage is a crucial step in saving your money. Consider rolling your credit card debt to 0% balance transfer credit cards. There are many credit cards available that provide you with 16-24 months interest free on balance transfers. If you qualify for these cards, this is a useful strategy for paying less interest and getting ahead on your repayments. To truly get out of debt, an important step is to cancel your original credit card and to make sure you pay off the new 0% balance transfer credit card before the introductory rate reverts to the normal high interest rate.
Renegotiate Your Mortgage (Or Get A Better Deal)
Contact your bank and see if you can negotiate a lower interest rate on your mortgage. This is as simple as a phone call and vaguely implying that you are considering swapping banks and can often result in a reduction in interest rate. Reducing your mortgage interest rate can do two things;
- save you money by reducing the amount of interest you pay and
- give you more cash flow toward paying off other debts with higher interest rates than your mortgage such as your car loan.
If your bank won’t budge it may be worthwhile shopping around to see if you can get a better deal with a different financial institution (bank, building society, credit union). You may also want to consider using the services of a professional i.e. a mortgage broker.
Depending on how much debt you have and how much of an issue cash flow is, consider rolling some of your loans into your mortgage, refinancing into one loan. Do this with caution however. This strategy is only advisable if you continue to pay the debt you roll into your mortgage at the same rate as you did when it was separate.
For example, if you owe $20,000 on a 5-year car loan with 8% interest, over the course of the 5 years you would’ve paid $4332 in interest. However, if you rolled that $20,000 into your mortgage over 25 years at 4% interest, you would end up paying $11,670 in interest on the car portion over the course of the loan.
|Total Interest Payable||$11,670||$4,332|
To make this a worthwhile strategy it is important to take advantage of the lower interest rates but keep your repayments at the original loan level. If you paid off a $20,000 car loan over 5 years at 4% interest, you would have paid only $2100 in interest and your monthly repayment would be less ($406 down to $368).
|Mortgage - Car Loan Combined|
|Total Interest Payable||$2,100|
The “car” repayments into your mortgage account need to be on top of what your mortgage minimum repayment. For example, if your home loan repayments were $2000 per month and the car repayments are $406 per month, then you should pay $2406 per month into your mortgage account to cover both the house and car repayments.
Step 4 – Make A Budget – Know Where Your Money Is Going
Start with your income. What is your take home income (income after tax. Also known as net pay).
Using your new minimum repayment balances, set yourself a budget. You can use online tools or you can do it yourself in an excel spreadsheet. List all your weekly, monthly, and quarterly bills. Set yourself reasonable budgets for variable bills such as food and petrol. Make sure you work your debt and discretionary expenses into your budget. Once you have worked out your total expenditure for each month, deduct this from your monthly income.
If you have money left over – this should be used to pay off more of your debt (starting with the debt with the highest interest rate as discussed earlier).
If you don’t have any money left over, and are in fact in the negative, this indicates that you need to make further lifestyle adjustments (going without the gym, less spending money, buying only home brand groceries etc.). You need to identify additional areas where you can save money so you are living within your means and your debt.
The federal government Money Smart website has the following budgeting tool – https://www.moneysmart.gov.au/tools-and-resources/calculators-and-apps/budget-planner
Step 5 – Decrease Your Expenses – Live Within Your Means
It is important to stick to your budget. If you have trouble curbing your spending or sticking to your allotted discretionary budget, use cash. Draw out your weekly spending money once a week and only use that.
Set up automatic payments so money is paid off your debts and bills as soon as you get paid. This can help remove temptation.
Step 6 – Increase Your Income – Look At Earning More Money And Put Windfall Money Towards Debts
It is obvious, the more money you earn, the faster you can pay off your debt. Sometimes this means you have to work more or harder. Overtime, second job, babysitting etc. see what you can organise to generate more income for yourself. It can also be taking advantage of the sharing economy and becoming a part time Uber driver or an Air BnB provider.
Windfall money is any money you receive that didn’t directly come from your employment e.g. tax returns, bonuses, inheritances, birthday money. It is easy to splurge or treat yourself with this money. Refrain. If you are in debt, then you really don’t have spare money to waste. Don’t blow it, use it to pay down or off some of your debt. You will feel better overall.
Once you have reduced the amount of interest you pay, consolidated (some or all) of your loans and start living within your means, debt reduction should follow. Consistency is the key. Stay on track. Depending on how far in debt you are, this could be a long process, but worth it in the end.
Step 7 – Sell or Trade In Big Ticket Items And That “Stuff” Around The House
Do you have a shiny car, caravan, or boat in the driveway? You can significantly reduce your total debt by trading in your car for something cheaper. If you can get $18,000 for a trade-in, and you can find a $10,000 car on the lot then you just came into $8,000 to help you pay off debt. If you can trade-in two cars and concede to just having one you could double or triple this amount. Plus, it reduces your annual expenditure.
You can further apply this to boats, yachts, jet-skis, motorbikes, or any other non-essential modes of transport. Now isn’t the time to have toys. You can have toys when you are debt free.
Once you have sold your big ticket items, or have traded down to less expensive versions, you can start selling more of your unwanted, unused “stuff” from around your house. Take the time to sort through your cupboards, junk room, garage and pick out the things you don’t need or use. A good way to figure out what you do need is to mark down the items you DO use in a week. It will be a lot less than you think. Anything you sell can be used to help pay down your debt. This is quite an easy and addictive strategy. With eBay, Gumtree and Buy, Sell, Swap pages on Facebook selling your junk (treasure?) has never been easier.
Step 8 – Get A Coach Or Support Person
It can be difficult to make the tough decisions that are required when you are emotionally attached to the reasons that got you there in the first place. Ask a friend, family member or a professional (a financial planner / financial advisor) for support. They can make decisions without any of your internal biases.
Contact Elliot Watson – Certified Financial Planner
Elliot Watson is an award winning CERTIFIED FINANCIAL PLANNER™ and enjoys helping clients achieve their financial goals. He is committed to building strong relationships with clients built on a foundation of open and honest communication. If you would like help achieving your financial goals, contact Elliot on 02 4032 7934 for a complimentary initial consultation.
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