The Debt Trap

Thursday, 29 July 2010 00:00

Nothing is more depressing or stressful than being in financial trouble. The real truth is few Americans have been educated or prepared to properly manage their finances. The Federal Reserve Board’s figures from 2003 showed 1.98 trillion in non-mortgage debt up from 1.5 trillion in 2000! That represents $18,700 per U.S. household! There are many reasons families and individuals let debt get out of control from lost jobs to simply poor fiscal management. The good news? It is not too late to get out of the debt trap! 

Getting out of the debt trap has to start with a financial plan which should include an evaluation of your current situation. You must evaluate your current debt one item at a time and make decisions on how you can attack each situation. Here are some guidelines to follow:

1. Which loans are carrying the highest interest rates? These are the credit cards and loans that hurt the most. There is a huge difference in monthly payments between a 12% credit card and an 18% credit card! Solutions: Transfer balances to a lower interest rate loan or card. You can also call the credit card company to negotiate a lower rate. One important note; as you pay down your credit cards, another factor to consider is getting balances below 50% of the maximum credit limit on each card. Cards above the 50% level affect your credit score the most.

2. If you are behind on payments to creditors, the worst thing you can do is “hide.” Proactively call and talk with your creditors. There is a possibility you may be able to work out a compromise on payments. The best time to call is before you are behind. Try to have your plan prepared when you call and the representative will be more willing to work with you.

3. Down size your credit cards! Cut up the cards that carry the highest interest rates and maintain only one card to be used for essentials. Also eliminate any gas cards, department store cards or any card that will tempt you to use credit. One important point: make sure you maintain at least four sources of credit to assist in your credit rating. Auto loans, a home loan, and some revolving credit will usually be enough.

4. Learn to use cash as much as possible and not from your credit card! Paying by cash, check, or debit card will stop you from increasing your debt!

5. Write down what you have spent for the past three months and put the expenditures into categories such as food, clothing, utilities, entertainment and dining out. You will be able to quickly see which areas are your biggest financial drains. This list will be the first step in creating a monthly budget that you must learn to stick by if you are to ever escape the debt trap. It is amazing how much monthly expense you can eliminate just by reviewing the “non-essentials” such as the daily newspaper, health club membership, baby sitters, stops at the coffee shop on the corner, excessive long distance charges, and eating out. Also, do not be an “energy hog” in your own home! Turn off lights and move the thermostat to reduce the need for air conditioning and heat. Substitute light bulbs with newer energy efficient ones.

Once you have made these important evaluations it is time to set an actual budget. If you have a family, it is important to get everyone involved in the budgeting process since everyone should be willing to do their share in reducing debt. A budget is simple to put together, just follow these steps:

1. Start backwards! Start with your total monthly take home pay after all taxes, insurance and automatic withdrawals. Any automatic withdrawals that are non-essential should be eliminated.

2. Next go back to your three-month expenditure list that you compiled in the beginning of your plan. Go over the “have to’s” such as health insurance, utilities, auto insurance, house payment, car payments and groceries. Come up with a total amount and decide if any “have to” expenditures can be reduced. An example might be to increase the deductible on your auto insurance to reduce the rate or start using coupons and eliminating luxury foods when grocery shopping. Once you have done this, come up with a final monthly budget on the essential expenditures.

3. Any amount you have left over should be assigned to debt reduction. If you only pay the minimum on each debt it will take years to pay each one off. Be aggressive when deciding how much to pay. Remember from part one of this plan, you may be able to negotiate a reduced interest rate or payment, but try to stay on track in eliminating the debt.

4. Look at what is termed “optional spending.” Entertainment would be in this category. It is great to do fun things but many of them can be low or no cost. Going to the movies for a family of four can easily run eighty dollars or more while a high school basketball game can be less than twenty dollars! This is another reason an entire family should be involved in these discussions.

5. When all categories are reviewed, make sure you have a cushion for unexpected expenses of around 10%.

6. Approach your budget with excitement and commitment! Every week, review your expenses and make adjustments if necessary. You will find that sticking to a budget, although not easy can be very rewarding when your debt starts to disappear and it becomes a little easier to sleep at night! CAUTION! As you begin to pay off your debt and reduce monthly expenses it is very easy to get back into the “spending trap!” Once you pay off one credit card, apply the extra payments to your remaining debt, not a dinner at an expensive restaurant or a new stereo!

There are other tips regarding getting out of the debt trap of which you should be aware. Let’s look at each one, giving you guidance in the process.

1. Be careful if you decide to use a credit counseling service. The USA Today reported that in 2002 there were 1,480 complaints regarding credit counselors, up from 261 in 1998. There are both private, non-profit and government sponsored credit counseling services. This should not be your first step. Take the initiative to create your own plan. If you still struggle, then credit counseling may be an alternative. Do not choose a service based on a television commercial! Do your homework! The National Foundation for Credit Counseling is an association for qualified, mostly non-profit credit counseling agencies, and is a good place to start your search if you choose this option. Most of their members are termed “CCCS” or “Consumer Credit Counseling Service.” The services can range from free to just a nominal fee each month for assisting you in managing your debt. Each NFCC member has to be accredited every four years through an independent agency and receives the “COA” approval which comes from the “Council on Accreditation.”

2. As mentioned earlier, put aside a contingency for unexpected expenses. If it means paying a little less on your loans, it is better than an unexpected expense that sets you back.

3. If all else fails, you many want to consider “Debtors Anonymous,” a free organization dedicated to individuals who need a support group and feel they cannot get out of debt on their own. The website is www.debtorsanonymous.org.

4. Attempt to get interest rates on loans lowered by creditors, but be careful regarding payoffs. If a creditor reduces the payoff, in most cases, it will be detrimental to your credit.

5. Consider a second job, a garage sale to raise cash, and even working odd jobs or overtime! Every little bit helps. Making the sacrifice will be a lesson well learned to avoid the debt trap again!

6. Remember the earlier advice, pay off the highest interest rate debt first and try to get below the 50% maximum level on credit cards and credit lines. There is one psychological “trick” that can help you see the light at the end of the debt tunnel. If you have cards with very low balances, make an extra effort to pay them off. Why? There is a psychological boost to totally eliminating a debt.

7. Attempt to avoid bankruptcy if at all possible. New federal laws make it tougher to file bankruptcy and it will stay on your credit for a long period of time affecting your ability to buy a home or even purchase a car at a competitive interest rate.

8. Remember, you can check your credit report once a year for free with the three main reporting agencies!

9. Check the fine print on any “transfer credit cards” that offer to consolidate your debt onto one card with a low monthly interest rate. Although the rate is low, many have default rates and penalties that are extremely high if you are late on a single payment!

Finally, one alternative to your debt is to attempt to refinance your home provided you have enough equity to pay off higher interest debt. Put a lot of thought into this option because you want to be sure you can handle the higher monthly payment of a “cash out refinance” since your principle balance will increase. A qualified loan consultant can assist you with making the right choice for you. In many cases you can reduce your debt by several hundred dollars a month while increasing your monthly house payment by a lesser amount.

Good luck as you focus on creating a financial future! Having solid credit, great spending and saving habits, as well as peace of mind will be more than worth the price you have to pay to get out of the debt trap and into a secure financial future!