Friday, December 31, 2010

Life and Debt Management - Part II

In Part I of Life and Debt Management, I talked a bit about cutting and restructuring elements from your life in terms of both time and material possessions. Another word for it is "sacrifice". Life and Debt Management, as a discipline, is about weighing out which sacrifices hurt most and in many cases selecting the less painful of the two. It may be less painful to have a debt than to give up a favorite past time, but down the road - what is it costing you? Having the long view of things is essential to making good decisions when it comes to your life and your debts.

Debt Management

I've mentioned before the excellent Total Money Makeover by Dave Ramsey. If you can barrow a copy or have enough cash to buy it, I can't recommend it enough as a resource for debt management strategies. So let's assume you're working some variation of the debt snow-ball and have a -tight- budget but you're still bleeding red ink. How do you restructure your debts to help this situation turn around?

In Part I, a major portion of the approach is finding the things you can eliminate, or restructure, to reduce expense and add to the plus-side of your budget. The strategy is very similar here but there may be some not-so-obvious applications.

Cutting debt sources should be obvious from Part I. If you can get rid of something that is costing you maintenance fees (a club membership or boat slip) or payments or premiums (insurance on your motorcycle which only sees the road in the summer), you're going to positively impact your cash flow. But let's say we have gotten rid of all we can really get rid of and we are still failing to produce a surplus. What now?


Consolidation is the core principle of the debt snow ball, but incrementally so. Instead of piling payments forward onto the next largest debt (a highly effective and gratifying way of killing debt which I urge you to utilize before consolidation ), we're going to group debts together into the largest single sum. The reason for this is that we tend to be able to get better lending rates for larger ticket items to which an equity can be attached. Your car and your home are considered equity or security against the debt they represent. When you take out the loan, you are basically staking the capital good as the guarantee that you will repay the loan. If you don't pay, your house will be taken to pay the mortgage through the foreclosure process or your car will be repossessed.

Because these assets anchor your debt and provide a base level of compensation to the lender if you default on your loan, you are given (typically) a better interest rate on your loan. Markets vary from one location to another and almost daily, but generally, you will be able to get a bank to issue a slightly better rate on a home or auto than a straight cash loan -- even if you list a home, car or other property as equity backing the cash loan.

So the objective with consolidation is to find and obtain the cheapest rate we can amongst all of our debt sources and then try to finance the sum of all debts on the one anchor or equity property. Some lenders are eager to do this - you may have heard of a home equity loan. Let me say I have used home equity and I do not recommend it. Taking a home equity loan if you still have a mortgage means there are two liens on the property and you are making two payments. If you can, refinance your existing mortgage and request the amount financed be more than the amount owed to pay the house (but NEVER more than what the house is worth!). Many lenders will allow this but regulations and tolerances change frequently. Ask around.

Doing a home refinance to consolidate debt is a popular tactic and means you can get credit cards and student and/or car loans rolled into one lump payment with a lower interest rate. Make no mistake: you are still paying interest and will be doing so for a long time, but now you have given yourself breathing room so that your monthly budget has a surplus.

So you consolidate your debt and now you are "debt free" except for your inflated mortgage. Now what? Be careful!!! If you fail to exercise discipline in managing your budget and your money (e.g. if you fail to CHANGE your behavior), you will soon have other debts and be stuck with more than you started with. DO NOT let loan consolidation give you "permission" to go get more debt! You will bury yourself FAST!

Also beware your house value declining. If you bought during a hot market and paid more than twice the state assessed value of your home, you probably paid what the market would bear rather than what people will be willing to say the house is worth when the market is cold. If the value of the property declines, you could wind up owing more than you can get by selling the property and find yourself "upside down". This is a painful and discouraging position to find yourself in, so DO YOUR HOMEWORK before getting into a refinancing scheme.

The same concept above can sometimes work for a car purchase if you secure the loan apart from the purchase of the vehicle. Typically, car dealers want to handle your financing and deal with their preferred lender. You have more leverage to buy the car if you secure a loan in advance since you don't have to "qualify" at the dealer. You typically get a letter from the bank indicating your credit worthiness up to a certain amount. This is not what you want - you want a cashiers check made out to you so you can go shopping and not have to come back to the bank and get less than you need to cover car + another debt or two. You can more easily and quickly walk away from a deal that isn't the best you can find to go find a better one when you know the financing is covered. The dealer has little power over you here, though you won't get the 0.0% dealer financing either. In this case, you might secure a $6,000 loan and buy a $5000 car, using the remaining $1,000 to eliminate a credit card debt. Be up front with the bank, however, when you do this. You do not want to misrepresent yourself and in many cases you'll need equity already in place (your spouses car or your home) to secure the loan.

Even if you're not buying or refinancing a larger item, you can sometimes take three credit cards and roll them over to a new one. Watch for promotional mailings offering you a short term reduced rate to do this. You'll get a good deal, consolidate and save some money in the short term. Pay attention to what your actual rate will be after the promotional rate expires, though. You may wind up with a worse rate if you don't make payments on time or follow the guidelines of the lender.


These strategies are for worst case scenarios only. Remember - the primary goal is to get rid of debt, not get new debt. But if your budget is as tight as you can make it and you still can't get a positive cash flow going, some form of consolidation may be the option of last resort. It's also important to recognize that consolidating debts makes them harder to get rid of. You might do yourself a favor in terms of short term budget flexibility, but if you fail to capitalize on this to provide a safety-net savings and living expense account, you'll be short changed if any hardship should come your way later.

If that isn't clear enough, let me put it another way. If you do NOT have a budget and are NOT working hard to eliminate debt and work to a savings plan, the above strategy can easily KILL you financially. Only do this when you are well prepared to set aside money for the basic freedom generating goals (emergency and cost of living) and RIGHT THEN AND THERE AFTER, direct your savings into your consolidated loan pay off. In this way, you have a meager bit of flexibility to protect yourself from falling off a cliff in terms of debt but -- and I STRESS -- it takes iron-willed discipline!

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