Debt Handling - Low Interest Credit Cards - Savior or Devil?
By Debt Handler | August 16, 2007
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Of course, the title is an exaggeration on both sides. Credit cards are neither your salvation nor a destroyer. They are a tool, and how you use that tool is up to you.
It can be used for the sake of convenience, for online shopping and the dozen other uses for which it was designed. Or, it can become a means of increasing your debt to absurd levels and cause you to pay painful amounts of unnecessary interest every month.
Many who let credit card debt get out of control see debt consolidation as the way out. They are often presented with a stack of offers to reduce their credit card debt by consolidating all their debt onto one credit card.
But those offers, though they frequently tout ‘lower interest rates’ should be viewed with a skeptical eye. Those lower interest rates are usually only available to a select few with very good credit ratings. That doesn’t apply to the typical person who is struggling to overcome a history of excessive debt and find a way out.
But, they can offer a way to solve the problem over the long term. You may, in fact, be able to qualify - the only way to be sure is to apply. But even if you’re accepted, there are several key items to keep in mind when considering this solution.
Very rarely will such credit card offers lower the actual amount of principal outstanding. As a result, you have exactly the same amount of debt on the day you acquire the new card. And, over the long term you will actually sometimes pay more.
A lower interest rate can, indeed, be a benefit. But lowering the rate doesn’t always mean lowering the total amount. If you pay 8% on a debt of $10,000 for, say, five years you will pay more than paying 10% on $10,000 for two years.
The reason is the compounding effect of interest. The total amount of interest paid in the first case is $2165.60. The net interest rate overall is 21.656% when calculated as the percentage paid beyond the principal. In the second case, you pay only $1074.80, with a net interest rate of 10.748%.
Remember the 8% vs 10% are the APR in each scenario - the annual percentage rate, this is the rate for a one year period - not the total percentage of interest.
Of course, the upside is that in the case of 8% over five years, you pay only $202.76 per month, in the second case you pay $461.45 per month. Many will find the former payment easier to manage than the latter. And, you may be able to find some middle ground. Calculators available online will help you run through the different scenarios, in order to guide you to choosing the one that’s best for you.
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Debt Handling - Inflation and Interest Rates
By Debt Handler | August 14, 2007
Inflation makes tomorrow’s dollars worth less than today’s. That makes borrowing more attractive to borrowers, but lending less attractive to lenders. In order to compensate, lenders raise interest rates, since (among other things) they too know that the dollars they will be repaid next month are worth less than the ones they loan out today.
So, a vicious cycle is set up. As prices rise, more people (businesses, too) find themselves needing to borrow more if they are to buy the things they want - cars, home improvement, etc. That tends to raise interest rates even further, since there is now more demand for borrowed money. More demand, given a set supply, tends to raise prices. In this case, the price (this is interest paid) is the price of borrowed money.
Since inflation is chiefly caused by governments - whether through high borrowing themselves, or deficit spending, or actual printing of more currency or issuing more credit - there is little an individual can do to change the system. All one can do as a citizen is recognize the causes and advocate sound policies.
But, as a borrower, there is much one can and should do when looking at the situation. After all, governments don’t continually increase inflation - if they did as happened in the late 1970s, for example, interest rates would eventually reach a point where there are loud demands to ‘do something’. When they ‘do something’ it invariably means closing down the spigot, this is reversing or at least slowing the actions listed above.
Those actions have a definite impact on anyone looking to borrow money, just as the inflation did. That deflation may lower rates, encouraging more borrowing, but it also causes dollars borrowed today to be worth less than they would be tomorrow. So you are repaying a loan with dollars that are worth more tomorrow if you held onto them (by saving or investing) than they are today.
So, when you consider borrowing you have to try to make a guess - just as the banks do - about which way inflationary or deflationary pressures are likely to go. That’s a tough job for even professional economists, so how can a laymen be expected to do that with any rationality?
While there’s no sure method, there are some indicators that are available to anyone. It used to be that gold and silver were good indicators, but that is no longer true since the dollar is no longer related to any hard commodity. Still, there are one or two that can be helpful.
Since oil is a very basic commodity that is tied to so much production of other things, as the price of oil rises inflation is likely to heat up some. So look at the price of oil options to see whether prices are expected to be higher or lower in the future.
The price of bond options going up is also an indicator. In this case it suggests that professional money managers are betting interest rates will change sharply over the coming year or two. The relationship is a little complicated and borrowers would do well to consult a specialist.
Just keep in mind that a dollar today is a measure of the cost of goods and services today, just as a dollar tomorrow is a measure of that cost tomorrow. But when borrowing money, you’re buying dollars today to spend today, but will pay them back in the future. How much those dollars are worth when you pay them back is a measure of what that loan will actually cost you.
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Debt Handling - Individual Voluntary Agreements - IVA
By Debt Handler | August 12, 2007
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In the UK there’s a formal name, IVA, for the agreement between a debtor and a creditor to alter debt terms. The U.S. may not employ the name, but the idea is essentially the same. It’s a method for agreeing to settle an outstanding debt, usually one that’s overdue and that the debtor can’t pay.
The UK has a much more formal structure for such agreements, and they often involve Licensed Insolvency Practitioners. The U.S. doesn’t have a recognized profession by that name, but debt counselors, financial advisers, some attorneys and others frequently perform the same role.
The agreement is never ideal for either party but, as in any compromise, it’s better than a total loss on either side. Such agreements involve setting terms for repayment, often with the creditor accepting a lower total amount than the original debt. Sometimes the interest rate is lowered, sometimes it’s not - each agreement is just what the term says, individual.
The advantages to the debtor are fairly obvious. He or she gains relief from any legal action such as garnishment of wages, asset seizure, home foreclosure, etc. There are also psychological benefits, since (presumably) the arrangement involves terms the debtor can actually meet. Once in place, a very unpleasant episode moves into a new phase.
But, the creditor benefits as well. The lender won’t usually receive the total expected amount. But such agreements can lengthen the terms of the original loan, and (even at a lower rate of interest) can bring in more money in the long run. More often, the debtor agrees to repay some percentage of the original amount. How much varies, but figures as low as 50% are not unknown and 75% is common.
That doesn’t sound like a great deal for a creditor, but if the debtor demonstrates that the amount is really all he or she can afford - and the alternative is the debtor filing bankruptcy or the creditor incurring legal costs to sue - it can be seen as the best available option for everyone.
One of the big advantages to a debtor is not just a lower amount of debt to repay, or even a lowered monthly payment, but simply what doesn’t happen. Avoiding bankruptcy is a major benefit. Bankruptcy, while some may see it as an easy way out, ruins your credit for several years.
After filing bankruptcy, it can be nearly impossible to obtain a home loan for 10 years. Auto loans will be difficult to get at anything near a favorable rate. Credit cards - of any kind but those with ruinous interest rates or that are just disguised debit cards - will be a memory. In today’s world that means restricted online shopping, difficulty making airline reservations and a host of other inconveniences.
In the UK, an IVA is a formal arrangement made through the courts. In the U.S. it can be nothing more than a signed letter containing the terms of the agreement. But it should be, at minimum, put in writing by the creditor. That gives the debtor a legally binding agreement that he or she can use as a reference and for legal protection.
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Debt Handling - Individual Retirement Accounts - IRA
By Debt Handler | August 10, 2007
Debt is closely tied to savings - the more you do the first, the less you have left over for the latter. Conversely, the more savings you have, the less you (usually) need or want to borrow. Since you’re paying out interest by borrowing, and (in some cases) simultaneously not getting interest by saving instead, you get a double financial whammy.
For example, instead of borrowing money by using your credit card, you could save that same amount every month until you had enough to buy the item you used the credit card to purchase. Only you can decide whether having the item today is worth paying the extra amount of money it cost in interest to own it.
But when it goes beyond individual items, into the realm of saving for retirement, you have a bigger issue to consider. An IRA (Individual Retirement Account) allows you to set aside money for your later years. That has multiple benefits and a few risks.
When you save that money, obviously, you are not spending it. You accumulate interest on that money saved, which compounds over time. See one of the many online calculators to get a feel for how compounding can help, for example, turn a few thousand into many thousands over 30 years. You also get a tax benefit, since by design any money put into the account represents a tax deduction.
Instead, you are taxed on that money when you begin to use it many years later. The theory is that you will then be at a much lower tax rate and therefore pay a much smaller amount than you would when it was first earned. Sometimes that theory is true in practice, and in some smaller number of cases it’s not. You will need to make some predictions for your own case, but for most people it’s true.
There are more variations today on basic IRAs than there were 20 years ago when the idea first became a reality. But the basics remain true. You can still put up to $2,000 per year tax free into the account.
One variation, for example, is the popular Roth IRA. Federal regulations allow tax-free withdrawals as long as the contributions remain in the account for five years and you are at least 59?, or it’s used for a first-time home purchase.
Another common savings instrument is the 401k, named after a provision in the 1978 Internal Revenue Code. These allow employers to put money that is tax-deferred into an account on the employees behalf. You pay no income tax on the money until it is withdrawn.
Those who have difficulty summoning the willpower to save often find these helpful, since it’s allocated before you see your paycheck. Here again there are numerous variations around today.
These and other savings methods can form part of a total financial plan that involves borrowing and investment in many forms. The more options you learn about, the better plan you can develop to maximize your hard earned dollars.
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Debt Handling - How To Handle Debt
By Debt Handler | August 8, 2007
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The first step to handling any problem, and excessive debt is no exception, is to focus on facts. Here, that means finding out how much you actually owe and what the monthly payments and interest costs.
It’s surprising, though maybe it shouldn’t be, how many people that are troubled by debt problems, don’t actually know how much monthly interest they’re paying. Part of the problem may be that they really don’t want to know. Considering how much it sometimes is, one can hardly blame them.
But the first step back to financial health is a good diagnosis. If you’re paying $200 per month in interest charges alone on a monthly net income, say, of $4,000, then you are paying 5% PER MONTH of your income for essentially nothing. It’s not entirely nothing, since you are enjoying the things you bought early. You would have had to save to purchase them outright. But is that worth 5% of your income?
When that $200 a month (and for many, it’s much more) becomes the total you can pay each month, you have reached a point where you will never pay off the debt. If all the money is going to interest none is going to principal. That may be an extreme case, but consider how much of the monthly payment in your circumstances goes for interest versus repayment of principal.
Suppose it’s 90% interest, 10% principal. That’s approximately the case for the average home loan for the first several years. You can use an online calculator to see how long that will take in your situation.
Suppose, for example, you owe $10,000 at 7%. You could pay only $116 per month, but it would take you 10 years to pay it off. The interest would cost you $3,933 - almost 40% of the total amount.
Now that you’ve seen your situation, you need to take two further steps. Develop a budget that will allow you to make payments as large as you can handle to get the bills paid off. You could use the ’snowball method’ and pay off the smallest one first. Then apply what you were paying to the smallest to the next smallest (now the smallest), until you’ve reached the end.
Alternatively you could pay down the largest bill. That would save you the most in interest charges, but it’s hard for many people to stick to it, when they see such slow progress.
Now, for the hardest - and most important - step (which should be carried out simultaneously with the first): stop borrowing. You should not allow yourself to incur any further debt until you have paid the first down to a reasonable level. That level is zero for credit card junkies. For others, it may be in the 5% range. For some with good willpower and are willing to eat the overhead, 20% is the maximum.
Facing reality and making a commitment to long-term change are the two hardest things for anyone who has entered financially turbulent waters to do. But they are the bare minimum required, if you want to recover your financial health and independence.
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