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What is the best way to reduce debt?

What is the best way to reduce debt? Consolidate, or attack the debt with the highest interest rate?

Unfortunately paying back debt is not as much fun as spending the money. To delay the pain is only human, but if you consolidate your debts and pay them off at a lower rate over a longer time period this can actually cost you more in interest.

Take the following simple interest example:

If your credit card had an outstanding debt of $10,000 and your interest rate was 18 per cent. The interest on $10,000 is $1,800 pa. So let’s assume you just pay the interest and then when you get a bonus at the end of the first year you pay $5,000 off the debt. The interest for the next 12 months is $900. Let’s assume you pay the credit card off with another bonus at the end of another 12 months so that after two years, the credit card is paid off and it cost you a total of $2,700 in interest.

Now let’s assume that instead of paying off your credit card in two years, you renegotiate the loan over ten years at a rate of seven per cent per annum, interest only. If you pay this loan off with $1,000 from your annual bonus over the next ten years, the interest cost is $3,850.

By paying off the loan over a longer time, you have incurred extra interest of $1,150.

And keep in mind this is the interest from one credit card – if you have more than one, you will be paying interest on each of these respectively!

The above seems the straightforward answer. But to really get to the bottom of this, you must read between the lines. In the first example, you paid more each year off the loan, a whopping $4,000 extra per annum. No matter what anyone tells you about saving money on your debts, the fact of the matter is that you are dealing with numbers and they do not lie. So paying more off the loan each year saves you interest and this is shown in the above example. That is, you paid off $5,000 per annum in the credit card example followed by only $1,000 per annum in the second example.

The next fact about borrowing is to pay the bank the least in fees and charges. The best way to do this is to have the lowest interest rate possible. You may get the lowest rate by using a standard loan with no fancy features or by trying to negotiate a better rate than the advertised rate (this can be harder than you think, banks usually only offer a lower rate if your lending is large, this is just like any business the more your purchase the more room they have to offer you a discount).

Therefore, the three things you should be doing are:

  1. Search around for a loan that you can obtain with the lowest interest rate and fees.
  2. Move your borrowing to this loan
  3. Pay it off as quickly as possible (you may need to put yourself on a strict budget to do this).

So using the above example, if you renegotiated the loan to an interest rate of seven per cent, then you pay off the loan with your bonuses of $5,000 per annum in two years (instead of 10) the interest cost is now only $1,050, this represents a saving of $1,650.

Your biggest obstacle is going to be finding a bank that will give you a loan at a low rate if you do not own a property.

Important information:This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

 

 

Published on: Thursday, October 29, 2009

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