Debt Free

With few exceptions, we all have debt. It sucks, but it's true. How you manage that debt is one of the primary determinants for your financial success or failure. You can even use your debt to contribute to your financial success, if you do it correctly. For most people, the goal is to become debt free, and not have to worry about debt ever again. The piece of mind you get from being out from under your debt is worth not using debt sourced capital for investing.

According to the U.S. Treasury Department, at the end of August, 2006 there was approximately $2,351.9 Billion (prelim.) in outstanding consumer credit held in the U.S.. That's almost $2.5 trillion! You can max out alot of Visa cards with that much money. The amount of outstanding consumer credit has been steadily increasing for the last five years, rising from $1,876B in 2001, to its present figure.

Every category has been increasing, although we've actually been financing less, in terms of loan to value, of our auto purchases. According to U.S. Federal Reserve statistics, loan to value ratio on auto purchases has receded form a high of 95% in 2003, down to 87% in mid 2006. This is not a one time decrease, as the figure has declined every quarter since the end of 2003. During the same time period, however, the interest rate we're paying on our auto loans (48 month average term) has increased from under 7% to almost 8% at commercial banks, while actually decreasing at auto finance companies, such as GMAC and FoMoCo. In 2001, consumers payed an average 5.65% new car interest. This dropped to a low of 3.4% in 2003, and is currently sitting at around 5.2%. Much of the decrease at auto finance companies can be accounted for by the proliferation of 0% financing offers major automakers have resorted to in an effort to speed up inventory turns. In addition, in loans obtained through auto financing companies, the term of the average new car loan has increased from 55.1 months at the end of 2001, to 61.9 months.

Revolving debt, such as credit cards and store charge accounts, actually comprises a smaller portion of our consumer debt now than it did in 2001, dropping from approximately 64% to 56%. Looking at the amount of credit card debt held by so many people, you'd think that would not be the case. However, much of the change can be attributed to the disproportionate increase in non-revolving debt from the proliferation of mortgages. To a great extent, the increase has been driven by favorable interest rates. So, even though people are paying lower interest rates on home and car loans, they're paying more in total interest, because the loan terms and amounts financed are increasing.

Back to actually managing your debt. What can you do to ensure you can get rid of most or all of your outstanding debt? What about proper debt management, to enable you to use some of your debt for investing and other purposes? First of all, don't think you're going to use money from credit cards to purchase investments and come out ahead. If you're using 0% cards, maybe. If not, there's virtually no chance you'll come out ahead with this strategy. The average credit card interest rate this quarter is over 14.5%. You'll have to be a pretty astute investor to maintain that rate of return. If you fail to, you'll be heading backwards.

Here are some important things you can do to manage your debt.

1- Pay all your debts on time, especially credit cards, car loans, and most importantly, your mortgage. This is huge. One of the primary ways credit card companies make money is by keeping your interest rate high. By paying your card late, you're playing right into their hands. In your credit card agreement, there are all sorts of terms and stipulations. In case you missed it, there is one that states they can raise your interest rate if you're are late on your payments. The actual terms vary by agreement, but the increase is most likely substantial, and can kick in almost immediately in many cases. If your rates do increase, you'll be stuck paying them on your entire card balance for at least 6 months.

2- Budget carefully and stick to it. It may well require a lifestyle change. Change it. Getting over extended is a sure way to violate rule number one. You'll also make more purchases than necessary using credit if you fail to maintain your budget. Put a line item in your budget for debt payment beyond the minimum payments, even if it is only $25. I, and many other PF bloggers, have made numerous posts on how to cut the fat from the budget and save money on your required purchases. Start using these methods to stay within your budget. You may not have to cut back your lifestyle as much as you think.

3- Roll up the stick, just like the airborne troops do. Start with the highest interest rate debt, pay it off, then take all the money you were paying on that debt and roll into paying debt number two. When debt two is gone as well, use the money from that one towards debt three, and so on, until all your debt is rolled up.

4- Pay off your debts first, then start your emergency funds or other general savings. You may not have an emergency, but you will definitely have to pay interest on your credit cards and other debt. Pay off the debt first, stop paying all that interest, and then put some away for emergencies. Many experts recommend at least 6 months expenses, but for many, that is much easier said than done. You can get a million people to argue with you on the question of paying off debt versus emergency savings accounts. If your credit balance is relatively low, they may be correct. However, if you've got substantial debt, your monthly interest payment is going to sabotage your efforts to save any money anyway. You need to get to the point where you're able to retain some of your funds, not give it to the finance company or bank for interest payments. Get that debt paid off ASAP.

5- View debt consolidation loans with skepticism. For some, they may be the correct solution. You must be in a position in which you absolutely can not lose your primary source of income, however. It's sad to say, but if things ever got really bad, you could default on your credit cards and revolving accounts. Your credit wouldn't be worth a damn, but as long as kept paying your mortgage, you'd be warm and dry. If you take out a large debt consolidation loan and default on it, you're shopping for an apartment. Good luck getting one too, because they'll require a credit check.

6- If you are going to have debt, use it to your advantage. Use the principle of leverage to make your debt work for you. This is not the best plan for everyone. Some people are far more comfortable simply being debt free. If you are a little less risk averse, the money you have in your home is the cheapest you'll ever have, in most cases.

You can use this cheap money to grow into more money. Some financial experts advise using the money in your mortgage by making only the minimum payments and stretching the mortgage out to it's full, 30 year term. If you have enough to pay extra on the mortgage, don't. Use that money to contribute to your investment accounts, start a business (can be extremely risky) or invest in real estate (ditto, but not quite as). You'll benefit from this money as long as your investment return rate consistently exceeds your mortgage interest rate. You'll be getting the mortgage interest tax deduction at the same time, further extending the benefit of this strategy.

Again, this is not the best plan for everyone. Some are better served or more comfortable simply paying off the mortgage early. Do this and you'll have piece of mind, and save substantially in total interest payments.

Remember, manage your debt. You can either make it work for you, or just get rid of it. It's up to you.