Buy Your Freedom
 

If you have debt here’s how to pay it off. First, don’t take on any more. Debt is bad for your personal finances unless it is used to buy low risk, appreciating assets such as real estate, or used to restructure existing debts, and even then only if it’s done in a conservative and beneficial way for you.

Debt is money you have already spent which you have not yet paid for, often because you have not earned the money to pay it. If you have debt, be it from a bank, credit card, merchant, or other lender, that creditor owns a part of you and your future earnings. You are not free. You are a type of indentured servant. And financial servitude means you cannot stop being a servant. The only way to gain your financial freedom is to pay off debt.

You overcome debt by establishing positive cashflow and then using the remaining funds to pay down principal, and thus interest. You must absolutely find a way to do that or you will never be financially successful. I cannot emphasize this point enough.

Types of Loans

There are two basic types of loans: Lines of credit and term loans. Most credit cards and lines of credits are revolving, which means you can borrow up to a certain amount and there is no fixed schedule to pay it back. You’re only required to pay interest on the outstanding principal for each billing period. Credit cards generally require some nominal amount of principal to be paid back each month as well, usually in the region of one to three percent of the principal. As you pay back the principal, you can borrow it again and again, as long as you stay below the total limit of your credit line. It’s easy to fall into the trap of only making minimum payments. This can be dangerous to your financial health if you aren’t careful in controlling spending. If you’re maxed out and your financial situation takes a turn for the worse, you’ll be even more hard pressed to make your payments.

Next, we look at term loans, or fixed rate loans, how they work, and how to make them work for you. They’re different in that the amount you borrow is fixed, and so is the interest rate, the duration of the loan, and the payment amounts. For example, if you borrow $10,000 for 5 years (60 months) at 7% annual interest rate, your payments would be about $198.01 each month, for a total of $11,880.60 ($198.01 x 60 months).

The advantage of credit lines is that you only borrow as much money as you need, right when you need it, and thus only pay interest on the amount you need. The disadvantage is that the interest rate can fluctuate rapidly if it’s not fixed. It’s not a problem if rates go down, but it can have a serious impact on you if they go up. Lock in lower rates whenever you can.

You already listed all of your outstanding debts including mortgages, auto loans, student loans, charge card debts, and credit card balances on your net worth worksheet in a previous section. Are you behind on any of the payments? If you are, you have to take care of those first by getting caught up on your payments. Since you’re behind on them, you probably already have negative or zero cashflow and cannot make the full payments. My suggestion is to reread the previous section on raising more cash, then take action and raise additional funds to get you through this step. If at all possible you want to avoid filing for bankruptcy or going further into debt. There is no way around this: Positive cashflow is the only solution.

Sort your loans by annual percentage rate (APR) in descending order. The one with the highest rate (APR) costs you the most. As long as you’re caught up, pay only the minimum on all of your other loans except the highest interest one. Pay as much as you can toward that one each month. What you’re doing, essentially, is putting your lower interest loans on hold by paying only interest and the bare minimum principal, and concentrating all your remaining funds on paying off the loan with the highest interest rate. Once it’s paid off, go on to your other debt with the next highest interest rate and pay it off as well. Work your way down to the final loan and pay that off too.

Where is all this money going to come from? It’s going to come from the money you’re saving by not spending on nonessentials combined with these three ideas:

• Lowering interest rates and finance charges where possible.
• Paying down loan balances.
• Lowering monthly payments, but only if necessary, to achieve positive cashflow.

If you have credit card debt, your next step is to get lower interest rates. Use Worksheet C (Figure 8 is an example) and call each of your credit card issuers and check what your interest rate (APR) is, and ask each one what your rate would be if you transferred a balance from another card. Be sure to note the finance charges for transferring, and how long you’ll get those rates too, as most promotional rates expire eventually and go up. Take note. Usually there is a finance charge of around 3% of the balance to be transferred, with some maximum limit, such as $50. This is in addition to regular interest. Once you have this information, compare what you’re paying with what you could be paying. Interest Rate A is the current rate for that account, while Interest Rate B is the new rate, if you successfully negotiate a better rate with that lender.

Figure 8

If you are carrying a balance on your credit card or any line of credit, the sooner you make each payment, the less interest you’ll accrue. Just because a statement says the due date is three weeks away, if you’re carrying a balance on it, pay the bill as soon as you can. Interest continues to accumulate daily. This is especially important on large balances, like a home equity loan.

At 12% APR on a $1,000 balance you’re looking at $0.33 a day in interest or $4.61 for a two week delay. If you were to pay $500 toward the balance, paying it two weeks earlier would save you $2.30 in interest. It’s not much but over time it can add up when you total all the months you have a balance and all the different loan balances you carry.

If you’re dealing with debt, there’s no reason to pay more interest than you absolutely must. Be conscious of the fact that interest accrues on your balances on a daily basis. The sooner you pay, the less you owe. The larger the balance and the larger your payments, the more you can save.

Major caveat: Do not be late with your credit card payments. Most cards will jack your interest rate way up for a long time if you’re at all late with a payment. To add insult to injury they will also hit you with a late fee each time you’re late, and it can do no good for your credit history to boot. These are all spelled out in the fine print of each card issuer’s policy. Be aware and make sure you’re on time. Even if you have to overnight a payment, it is still worth it.

Every Payment Is a Loan

Let’s look at the mechanics of how interest and term loans work, and how to make them work for you. Let’s say you take out a mortgage for $100,000 at 7% annual interest with a fixed monthly payment for 30 years. Your monthly payment is $665.30. You’re not really borrowing $100,000. You’re really borrowing $239,508. That’s how much you’re going to have to pay back ($665.30 x 360 months) if you make the minimum monthly payment.

When you look at Figure 9 you see that, while the total payment of $665.30 is the same every month the amount of interest steadily decreases while the principal increases. What this means is you’re really borrowing $81.97 for a month, $82.44 for two months, $82.93 for three months, all the way until the 360th payment where you will have borrowed $664.40 for the full 360 months. See Appendix 1 for the full 360 month payment schedule, and Appendix 2 for the 180 month (15 year) payment schedule for the same amount and interest rate.

Figure 9

If you follow the regular payment schedule for a term loan, every payment covers the interest on the entire loan balance for that month plus some amount of principal. Each month the interest you owe will be a little less than the month before because you reduced the principal balance by some amount with the previous payment. Since your payment amount is fixed, if you owe less interest each month than the month before, the amount of your payment that is applied to principal increases with each payment.

Put another way, the $664.40 you borrowed for the full 360 months means you’re paying interest on it for 30 full years. You also borrowed $657.59 for 359 months. You have to pay interest on it the whole time too.

Every dollar you pay toward principal beyond the minimum regular payment is a dollar you don’t have to pay any more interest on – ever. So the sooner in a term loan you pay off each dollar, the more in interest you will save over the life of the loan. This is one of the most important financial concepts to understand.

Time can be your great ally or foe. It is your ally when it is working with and for you by compounding your money. It is your foe when it is working against you by compounding your debts. Make it your ally. It can set you free.

Secured and Unsecured Loans

Suppose you borrow money from your bank or credit union using equity in your home or other assets as collateral. You’d have a secured loan which enables you to borrow at a lower interest rate because there’s less risk to the lender. But that does not mean there’s less risk to you. If you don’t pay, the lender has the right to take possession of the security (your house, your car, etc.) and sell it to recoup the loss. That’s why secured loans tend to have lower interest rates. You guarantee the loan with collateral, so the lender’s risk is less. Just remember this. When you borrow, make sure you can pay it back.

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