This is a guest article by Laura, a twenty-something woman working to improve her finances and reduce debt. She writes about personal finance for college students and grads at Green Panda Treehouse.

We’re buying a town house and it has a been a huge learning process. We have been running the numbers and making sure everything works budget wise. While looking through some books and blogs, I noticed some people mention getting a 15 year fixed rate mortgage instead of a 30 year fixed rate mortgage.

Talking with friends and family, many of them advocate getting a 30 year mortgage and paying it off in 15 years. Their reasoning is this gives you some flexibility. I wanted to run the numbers and see if this is a viable solution.

How much money you can save with a 15-year mortgage

Many people may not realize the financial upside of having a fixed 15-year mortgage. Besides paying less total interest, they typically have lower interest rates than 30-year fixed mortgages. Most of your money in the beginning of your mortgage payments goes to interest. As you move further and further along, more and more of your money goes towards principal.

Comparing a $200,000 fixed-rate mortgage for 30 years at 5.25% and a mortgage for 15 years at 5%, you get the following results:

You save a total of $112,901.39 in interest going with the 15-year fixed mortgage. Could you use that $112,901.39 for something else?

The downside of a 15-year mortgage

The downside for a 15-year mortgage is the same as any other mortgage: affordability. If you can afford a 15-year mortgage comfortably, congratulations. This is a great option for paying less interest over the life of the loan.

If money will be very tight with a 15-year mortgage and you are a bit hesitant with the monthly budget, you have two options:

• Wait until you have enough buffer room in your monthly budget for a 15 year. Save up while you’re waiting and put down a larger down payment.
• Decide to get a 30 year loan and come up with a plan to accelerate your loan.

You also have to weigh the opportunity costs of the money difference. That extra money could be redirected to investing more into the stock market for retirement or some other financial decision.

Will you pay a 30-year fixed mortgage in 15-years?

Dave Ramsey mentions the statistic that more than 97% of people who planned to pay their 30-year mortgage in 15-years do not. He has seen from his personal experience running his program that people lack the will power to keep up regularly with mortgage payments.

Ramit also observes that many people believe that they are the exception to the rule. This can lead some to not prepare properly. You may plan on paying your mortgage in 15 years, but if you rely on pure will power, you can set yourself up for failure.

Why pay off a mortgage sooner?

There are a few reasons why someone wants to pay off their mortgage sooner than 30 years. One popular reason is that they want the “peace of mind” in owning their home outright. If they lost their job, or if they experienced a pay cut, people would feel better knowing they did not have a mortgage hanging over their head.

How to accelerate your mortgage payments yourself

You can accelerate your payments even if you have a 30-year fixed rate mortgage. Automating payments can help you pay off your mortgage sooner and avoid some mental barriers to staying focused on your goal. By not managing the payments personally on a on a monthly basis, you can increase your chances of paying off the mortgage a lot sooner.

1. Start by examining your budget line by line. Know exactly what your actual income and expenses are. This will save you time from adjusting payments often as you realize you overestimated what you can put in.
2. Have a buffer. If you don’t have a fully funded emergency fund, consider getting that taken care of before accelerating mortgage payments.
3. Set up an automated payment plan. You can go through your mortgage company or you can go through your online bill pay. Note: Some mortgage companies offer programs to send extra payments but they cost you some money.
4. Start off with an extra payment that leaves you some wiggle room. As you get a raise in your income, increase your accelerated payments little by little. By adjusting it every year or so with your raise, you are accelerating your payments without missing the money.
5. Automation is key. You can build your payments up through the years while still having money to invest for retirement, save for other goals, and pay your bills.

This automated system can give you some flexibility in case your income decreases, like a pay cut or lay off. You simply pause or lower your extra payments and put them into your savings account as needed.

Even if you don’t hit the 15 year mark, you will still save tens of thousands of dollars by avoiding more interest payments. Think about it, you’re saving couple of years of salary for less than an hour of work spent on a phone call and online bill payment! I think that’s a great trade off.

Mortgage contact information

If you’re going through your mortgage company, check with them to see if there is a prepayment penalty or any fees associated with the accelerated payments.

• Bank of America: (866) 642-0987
• Chase: (866) 461-5953
• Citi: (800) 283-7918
• MetLife: (888) 638-6964
• Wells Fargo: (866) 234-8271

What about you?

What kind of mortgage do you have? Are you prepaying it? Why or why not? What suggestions do you have? Please also share your experience working with the mortgage company on prepaying your loan.

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Paying Off a 30-Year Fixed-Rate Mortgage in 15 Years

Yesterday I received an email from a Consumerism Commentary reader who has a question about her mortgage refinancing options and is looking for advice. I tend not to offer too much personal advice, but I responded with some thoughts and offered to open up the discussion to other readers. Please read through and see if you have any thoughts for Heather. Please feel free to leave a comment after this post.

Hi. I’m a long-time reader of your blog, occasional commenter, and I thought you might have an opinion. My husband and I are looking for advice.

We paid $319,900 for our house almost four years ago. We put $120,000 down and got a 30-year fixed at 5.875%.

We were looking at refinancing and were offered 5% with one point, making the total loan around $196,000. We anticipated our house currently being worth roughly $220,000. Using the Fannie Mae Refinance Plus Program, since we did not previously pay mortgage insurance, we would not need to again.

Our appraisal just came in at $190,000. If we want the same rate, we’d now need to pay 2.3 points, which would put our loan at roughly $198,700, which is both a much larger up-front cost but more distressing, it immediately puts us upside down.

We’re not sure if this is still a good decision. Do you have any thoughts?

I initially responded to Heather some additional questions to clarify her situation. Here are more details.

Q: Do you intend and reasonably expect to stay in the house or do you think you might sell and move within the next few years?

A: We are reasonably planning to stay in this house. (In my ideal world, we’d move closer to where I work, but in real life, after having lost so much value and sinking $60K into structural repairs, we’re not going anywhere.)

Q: Are the monthly payments unmanageable with your current mortgage?

A: Our monthly expenses are not unmanageable at all. Besides the mortgage, we have one car loan and one student loan, but no other debt. Both of us are teachers, and both of our districts both gave pay cuts and increased copays/deductibles. So while expenses aren’t necessarily going up, our income went down. My husband decreased his 457 contributions, which I didn’t agree with but it was a fight not worth fighting.

Q: How do you intend to use your freed-up cash flow (such as invest, pay other bills that are being neglected, save, etc.) if you don’t mind sharing.

A: At this point, the $120-ish per month that we’d save would really allow us not to cut back as much. I have a few side interests that I’m hoping will turn profitable, but in the short term, I can’t count on that at all. (I’m good with ideas and with doing, but I’m not good at marketing/selling myself. Working on it.)

Also, we gave the nice refi guy $495 to lock the rate and get the ball moving. At least $350 of that is not refundable, as it paid for the appraisal. I don’t know at this point if the remaining $145 is refundable or not.

We need to get him an answer in the next couple of days, as far as I know.

Happy to answer any other questions as wanted/needed.

Do you have any suggestions for Heather? Please feel free to leave your thoughts in the comments.

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Help a Reader: Move Forward With Mortgage Refinance?

There are many differing opinions about whether you can assign a quality like “good” or “bad” to debt. In general, I tend to believe that if debt is providing access to a necessary asset, like an education, a car, or a house, debt is at the least understandable. With debt, there is always a risk, and when you owe money to any other entity, you are often forced to live by their rules. So if freedom, financial and otherwise, is a goal, one of the major strategies on the path towards that goal is to eliminate your debt.

In an economic environment where your income is more at risk, you may choose to beef up your emergency fund rather than pay off debt. In other situations, debt is often not worth the interest you are required to pay.

Here are 50 things you can do right now to help you get out of debt. Some of these tips will directly help you pay off debt while some will help you save money so you have more cash available to eliminate that debt.

1. Link your debt account to your savings account and set up automated payments.
2. Stop using your credit cards.
3. Decide on a debt repayment method that makes sense for you while understanding the pros and cons of each.
4. Plan a party for each milestone, but don’t go into debt in order to celebrate.
5. Pay cash.
6. Empty the change from your pockets into a change jar each day.
7. Deposit that cash each month and transfer the amount to your larges or most expensive debt.
8. Make a second mortgage payment or car payment each month if you’re not penalized for doing so.
9. Cancel magazine subscriptions and divert that money towards your debt.
10. Postpone your vacation until you are out of debt.
11. Track your spending.
12. Stop watching television, particularly the commercials.
13. Don’t fall for Keeping Up With the Joneses; they’re in more debt than you.
14. Avoid scams and gurus that promise to make you rich quickly.
15. Learn how to cook rather than dining out.
16. Downsize your lifestyle: move into a less expensive house or apartment.
17. Divert the full amount of your raise directly to your debt.
18. Sell your unneeded stuff on eBay or Craiglist.
19. Give away anything you can’t sell.
20. Dispose of anything you can’t give away.
21. Put your credit cards in a cup of water in the freezer.
22. Call the credit card issuers to selectively cancel your credit cards.
23. Review your three free annual credit reports to ensure you’re aware of all of your debt.
24. Get your free credit score from CreditKarma as often as you like.
25. Involve your family and friends by letting them know of your plan.
26. Start a personal finance blog to chronicle your debt reduction adventure.
27. Use the library rather than buying books at the bookstore, renting movies from Netflix or the store, and buying CDs from Amazon.com.
28. Realize the ability to eliminate debt is completely within your control.
29. Use extra time to turn your hobby into a money-making business.
30. Modify your budget and find room to use more of your income to pay off debt.
31. Grow your own food in a garden.
32. When you need to replace your car, buy a used model with a great track record.
33. Wait before adopting the latest technologies until they are no longer the “latest.”
34. Remove the temptation to spend on things you like rather than the things you need.
35. Use smart credit card balance transfers to make your debt less expensive.
36. Improve your health to lower your health care expenses, and use those savings to reduce debt.
37. Quit smoking to save money and health expenses.
38. Read more blogs and personal success stories about getting out of debt.
39. Cancel your cable service.
40. Gradually increase your thermostat one degree each week during the summer or decrease it one degree each week during the winter.
41. Eliminate expensive hobbies that do not provide a return on your investment.
42. Stop trying to time the market and invest in individual stocks, and use that money to pay off your debt.
43. Downgrade your phone from your expensive iPhone or BlackBerry plan to a basic service without extra features.
44. Set up motivational reminders or alerts in your calendar software.
45. Save first, then spend, for everything.
46. Create subaccounts at ING Direct to identify money destined for eliminating debt.
47. Organize your bills in a system that ensures you won’t lose them or pay them late.
48. Always pay your bills on time, the earlier the better.
49. Don’t acquire more debt.
50. Speak up! Be part of a community; any tough task is made easier by working together and sharing ideas.

The Consumerism Commentary Podcast is in full swing with new episodes every Sunday. Listen and subscribe now!

50 Actions You Can Take Right Now to Pay Off Debt

While it’s great to avoid debt whenever possible, if you have to deal with federal student loans, including Stafford and PLUS loans, you might qualify for some better deals starting July 1.

Interest rates will be at the lowest rates in years. If you can consolidate, lock in rates after July 1. They will be at the lowest levels since the inception of the federal student loan program. The interest rate for graduates who are in a grace period is 2.00%.

Former students now in the process of repaying their variable rate federal student loans will be able to lock in a rate of 2.50%. Parents who have taken PLUS loans will be able to consolidate at 3.38%.

There aren’t many places to find cheaper money than this, but there are a few of limitations:

• Former students who have already consolidated are not eligible for these low rates.
• These rates are only valid for loans originated before July 1, 2006.
• Borrowers who are still in school do not qualify for consolidation.

There is more good news.

Income-based repayment. If a borrower is not earning enough to make monthly payments, they can apply for income-based repayment. The lender can extend the life of the loan and lower your payments to 15% of your income.

Student loan forgiveness. Borrowers who work for non-profit companies or the government will qualify for student loan forgiveness. After 120 payments (ten years), the government will write off any balance remaining on the loan. Student loan forgiveness applies to people who do not work for the public sector as well if they are repaying on an income-based repayment plan. In this case, 25 years of payments are necessary before the remainder of the loan will be forgiven, but will be considered income for tax purposes.

Rates for new student loans. Subsidized Stafford student loans will sport a new interest rate of 5.6% if the first disbursement is taken between July 1, 2009 and June 30, 2010. This is the second of four annual interest rate drops for new loans.

Increased Pell Grant scholarship maximum. Low and middle-income families might qualify for a Pell Grant scholarship. The maximum a student might receive from this federal program will increase on July 1 to $5,350.

These programs can save families thousands of dollars throughout the life of the repayment.

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Changes to Student Loans Coming July 1

On a macro level, debt was a force behind the incredible economic expansion over the past two centuries, and the availability of debt at the family level played a role as well. Despite all that debt has brought society, many financial gurus and authors vilify debt and explicitly call the idea of borrowing money “evil.” Typical mass-produced financial advice often calls for avoiding debt as much as possible. Is this a realistic goal in economically developed nations in the twenty-first century?

For some, it is. There is no doubt that there are many ways families can survive and thrive while avoiding the need to borrow money at all. Avoidance of all debt can be a struggle for most families, particularly in today’s United States. Are the sacrifices worth the effort?

To join in this discussion, you must accept that debt is not evil. All forms of money are tools to simplify the exchange of goods and services. As tools are objects with no inner consciousness, they can neither be good nor evil, as these words indicate a nature of intentions. Intentions require a sophisticated neural network, something lacking as much in money as it is lacking in a doorknob.

If you’re still with me and you agree that borrowing money is not an evil concept, you might also agree that the tool of debt could possibly be used for both wise and unwise decisions, designed by the active neural networks in human beings (the tool-wielders).

From a pure numerical viewpoint

Even though amounts and values of money are normally symbolized by numbers, money is never solely about digits on a ledger. If it were, there would be only one reason to go into debt: an opportunity to use someone else’s money to earn more money than what is borrowed — a sure thing. If I offered you $10,000 without interest with the only caveat that you repay me slowly each month and in full by the end of twelve months, it would be wise to accept the offer, invest the $10,000 in a safe investment like a high-yield savings account, pay me back, and keep the interest you’ve earned for yourself without much effort.

This is what credit cards have been offering, though less frequently recently, with 0% balance transfer offers, or so they’d like you to believe. If you look deeper, there are usually some risks:

• The credit card companies might drop the promotion.
• If you fail to make a payment in time, even if your check arrives on someone’s desk one minute too late, you will owe interest to the credit card.
• The bank might lower the interest rate you are earning in the savings account to a point where the exercise is not worthwhile.
• Your credit score will decrease due to an increased utilization ratio, forcing you to pay more for new loans or mortgages.

The numbers are trickier when you question whether to take on debt at a higher interest rate with the possibility of earning more from a riskier investment, like stocks. Here you have to weigh the probability of not earning more than the interest you will be charged for borrowing the money.

In the end it is a judgment call. You could devise complex algorithms to help you to decide whether to borrow money at one rate for the possibility of earning a higher return on an investment, but anything can happen.

Debt for education

One of the most prominent rationalizations for accepting debt for education, like student loans, is from the purely mathematical viewpoint. People who go to college earn more throughout their lifetime than people who do not. The numbers show that in many cases, money spent for college, including interest payments lasting ten years after graduation, are worthwhile thanks to increased career opportunities and salaries. On average, an individual with a Bachelor’s degree will earn twice as much as an individual with only a high school diploma, though the statistics will differ depending on the field of study and the career.

Thus, it often makes mathematical sense to enter into debt to obtain a Bachelor’s degree, if necessary. There are ways to avoid education debt, such as having parents who have earned and saved enough money to fully fund the education, choosing a free or less expensive school, obtaining grants or scholarships, or even working. When these options fail, the possibility remains that choosing to attend and graduate from a certain college and accruing debt will be a better decision than not earning the degree at all.

Student loans can generally be found with low interest rates or with a portion of the interest being subsidized by the government because it is in society’s best interest to produce a well-educated workforce and thinkforce.

Your career’s start-up expenses

When a new company is formed with a visionary idea, there are often required start-up expenses. These include finding real estate for an office or storefront, furnishing the office or acquiring inventory, hiring employees and paying them salaries, and spreading the word about the new business. I like to compare this process with a recently-graduated student entering a career. Unless the business has received help from investors (who often require that they become part owners), these start-up companies rely on loans.

Similarly, in some cases new employees can be excused for using debt to put them in a competitive position for starting their careers. Dressing appropriately and presenting a professional appearance requires expenditures for which a newly-minted graduate may not be financially prepared. (This is one reason I suggested the gift of clothing or gift cards for recent graduates.) Attending networking events, sending out resumes and traveling to interviews are all start-up expenses that must be financed in order to land the right job.

That first job is an important indicator of the remainder of your career, particularly if you remain in the same career path your entire life (as fewer people do). The better placed and paid you are in your first job, the higher your income will be throughout your career.

If necessary, a moderate amount of debt at the point you start your career will provide the opportunities to place you in a better position for future earning.

Owning a house

Thanks to the prevalence and availability of debt, consumers have reached higher and higher beyond their means. In the 1960s, median house prices were about 2.5 times the median annual household salary and at the height of the housing market in the early part of this century, the multiple was around 5 (source). Saving to pay for a house with cash could take years or even decades.

During the height of the housing frenzy, many families were willing to take on debt using the above numerical viewpoint. House prices seemed to go up without fail, and the prospect of earning more by leveraging a house purchase with debt seemed to make financial sense. Unfortunately, the underlying assumption that real estate prices always increase proved to be incorrect and many families were hurt due to over-leverage.

But that doesn’t mean that it’s never wise to buy a house with help from a loan. Buying a home should not be a purely financial decision. Families often want to create a stable home environment, and settling down in a location with the intent to stay for several decades is a key component of that idea. Furthermore, families with children want to ensure that the free public education offers a quality experience, and regions known for excellent education, in high demand, will often be more expensive.

A mortgage, while a decades-long debt sentence, is not evil. It makes sense for families to live in the best location they desire if they can afford the debt payments.

When else is debt worthwhile?

If you accept debt into your life, there are sacrifices you will need to make. You will also need to accept other sacrifices if you refuse to enter debt. It comes down to personal choice. Is it crazy to be willing to accept debt, as long as it is affordable and well-purposed? Or do you agree with idea that money is a non-intentioned tool, to be used in whatever situation logically calls for it? Are there any other instances where it can be a smart decision to take on debt?

Photo credits: mathplourde, snapped_up

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When Going Into Debt is Worthwhile

Not only are most personal bankruptcies due to medical bills beyond the ability of the consumer to pay, but most of the households declaring bankruptcy for this reason do so despite having health insurance coverage.

Researchers from Harvard Law School, Harvard Medical School, and Ohio University reported 60 percent of personal bankruptcies in the United States involved medical bills, an increase of 50 percent over the past six years. Furthermore, seventy-five percent of those bankruptcies were claimed despite having health insurance, intended to cover medical expenses and prevent unaffordable bills.

The researchers indicated that only 29 percent of those who declared bankruptcy explicitly cite medical bills as the cause, but the 60 percent figure includes households with medical bills totaling more than 10 percent of family income.

Health insurance appears to be useless when it is most needed. Twenty-five percent of insurance companies cancel coverage immediately when an individual covered suffers a disabling illness. Within a year, another twenty-five percent of insurers cancel coverage.

Even with medical coverage, here are the average bills, out of pocket, for some of the most expensive conditions:

• Multiple sclerosis: $34,167
• Diabetes: $26,971
• Injuries: $25,096
• Stroke: $23,380
• Heart disease: $21,955

The study was funded by the Robert Wood Johnson Foundation and will appear in the August edition of the American Journal of Medicine.

Medical bills underlie 60 percent of U.S. bankruptcies: study, Reuters, June 4, 2009

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Majority of Bankruptcies Due to Medical Bills

Yesterday, Consumerism Commentary reader Ryan suggested I write about interest-only mortgages.

There is no such thing as an “interest-only mortgage.” Wouldn’t that be nice, though, to have a mortgage that did not require you to pay any principal back to the lender? Unfortunately, when you become a borrower, your lender will insist upon receiving interest payments as well as principal at some point. What does exist, however, is an interest-only payment option for mortgages. The interest-only payment option can apply to adjustable-rate mortgages and fixed-rate mortgages alike. The purpose is to allow borrowers to reduce monthly payments for a period of time. Rather than a monthly payment of $1,200, in which $600 goes to interest and $600 goes to the principal, the monthly payment would only be $600.

The lower monthly payments during the interest-only period are good for households with irregular income such as commission payments less frequent than monthly, or households with unpredictable income, like that of a business owner who is expecting low income while the business is in a period of growth.

Interest-only payment options also allow borrowers to “afford” a more expensive home. This can be important for an executive who needs to entertain clients at home and its appearance is crucial to career success, but there could be a strong desire to use the lower payments to buy a home beyond the means of the borrower.

This is a dangerous prospect, especially in an environment where we can’t be sure whether the value of the house will rise in the short term. While making interest-only payments, the borrower is not building equity in the house. if the borrower is not building equity, the concept is similar to renting, particularly if home values are stagnant or decline. The amount you owe on the mortgage will never decrease. Even worse, some interest-only payments don’t cover the full amount of interest due each month. The excess, non-paid interest would then be tacked onto the principal, causing the borrower to owe more in principal than the home was worth when purchased.

When house values are declining, like they have been in many areas of the United States, this problem is compounded. Not only does the borrower owe the full purchased value of the house while making the interest-only payments, but the house’s declining values means the borrower will quickly owe more than the home is worth. Then, if it is sold, the borrower could owe more money to the lender than he received in the sale.

Interest-only payment options don’t last forever. After the interest-only period ends, the lender will expect the borrower to start paying back the principal. This can result in a significant increase in the number written on the checks sent to the lender. If the income hasn’t increased as expected or if the business has not moved past the “growth” stage, the new payment — a larger payment than you would have had throughout the life of the mortgage if the interest-only option was not selected — might be unaffordable.

The Federal Reserve Board has a helpful comparison chart outlining the differences in payments you might expect if you choose an interest-only payment option, reproduced below. Notice how low the equity is in the last column, identifying borrowers who opt for the interest-only method.

Do you have or have you had an interest-only payment option on a mortgage? Please share your experiences or opinions.

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Pros and Cons of Interest-Only Mortgage Payments

When someone who has accumulated debt across a number of credit cards embarks on the journey to rid himself or herself of this debt, and when that person is generating enough monthly income to cover all expenses and the minimum payments due on all cards with additional funds left over, there are two main philosophies describing the best way to achieve this goal. Although all approaches are good, there is no question where I stand on this issue.

I suggest following the path that affords the opportunity to get rid of debt as quickly and as cheaply as possible. This method has many names, but I’ve called it the Debt Avalanche in the past. The opposing viewpoint, popularized by author and guru Dave Ramsey, suggests paying off debt in such a way that it might take more time and be more expensive but offers “quick wins” which help some people gain encouragement and momentum at the earliest stages of the process. And there are, of course, many points of view that present a compromise between these two extremes.

The snowball approach to debt reduction

By ordering your credit card debts from lowest balance to highest balance and paying the minimums to all except the first on the list each month, you will pay off your first debt sooner than by following any other method. If you need encouragement to continue your journey as you pay off debt, you can celebrate after your first credit card has a zero balance.

Not everyone requires this type of extra motivation for paying off debt. Additionally, even those who need extra motivation may not suffer by choosing a cheaper and quicker method of paying off debt. The “quick win” of paying off the first debt could come just as quickly by using the Debt Avalanche. But even if the first payoff doesn’t come as quickly, you can redefine your first milestone to allow yourself helpful celebrations as explained in the next section.

J.D. Roth from Get Rich Slowly has seen success with the Debt Snowball approach, as have many others. It is the most widely marketed philosophy.

For an illustration of the monthly process of sending minimum payments to all credit cards except the one on top, regardless of how the debts are ordered, see this visualization from No Credit Needed.

One major problem I have with the above snowball approach is that your largest balance may be significantly more expensive than your smallest balance. Today it is not difficult to find a default interest rate on a credit card north of 30%. There is no way in good conscience I could recommend holding off on eliminating a debt this expensive in favor of paying off a small balance with a 7.9% interest rate. The same goes for payday loans, whose fees can border on usurious if interpreted as interest rates.

The avalanche approach to debt reduction

There is no question that anyone who follows this alternate approach to its conclusion will have emerged from debt sooner and by paying the least amount of interest possible. Some people argue that it is not as likely for someone to follow the Debt Avalanche through, but there are no data to support this. By ordering your credit card debts from the most expensive (highest interest rate) to the least expensive and paying the minimum each month to all cards except the first on the list, you reduce your interest payments quicker.

Since this is a mathematical approach, critics say it doesn’t take into account the emotions that come into play when dealing with money. It is true that emotions — your feelings about money — play an important role in financial decisions, and although this is a mathematical approach, how you feel about money still is represented in this method.

• If you follow the Debt Avalanche method, you can feel good knowing that you’ve made a sound decision and will spend less money than others who take a different approach.
• You can motivate yourself throughout by creating your own milestones for achievement, including paying off your first credit card, paying off $1,000 (or some other meaningful amount), or consistently reducing debt for six months (or some other meaningful time frame).
• Your emotions may be the cause of your debt in the first place. While they obviously cannot be eliminated, learning to focus on the best mathematical approach for certain financial decisions can improve your overall relationship with money.

I outlined the details of the Debt Avalanche last year. Trent from The Simple Dollar also likes the Debt Avalanche approach and Five Cent Nickel explains how Dave Ramsey is bad at math.

Other approaches to debt reduction

The hybrid approach. Somewhere between a snowball and an avalanche lives this hybrid. The concept here is simple. Order the credit cards from highest interest rate to lowest, like the Debt Avalanche, but move the card with the lowest balance to the top. This will provide a “quick win” if necessary but could still save significant money and time when compared to the Debt Snowball approach.

Pay the most annoying debts off first. This approach plays directly into the human psyche. The urge to eliminate a persistent itch is strong enough to motivate anyone to scratch, just ask any kid with chicken pox. Stephanie from Poorer Than You is a fan of this approach. This works well when you include debts other than credit cards. If you have a personal loan from a family member, I usually suggest paying that debt off the quickest while paying minimums to your credit card to help retain good will within close relationships.

Baker from Man vs. Debt says the same thing slightly differently: Pay off the debt with the highest emotional impact first. The argument here is simple. For some people the debts with the highest emotional impact are simply the debts with the highest interest rate, while others have a different psychological composition requiring alternate focus. You can’t go wrong by this approach which if continued will help you feel better quicker.

So what is the “right” answer?

It is easy to say, “Do what works for you,” and allow the debtor to come to his or her own conclusions. This can be a dangerous approach as it invites people to skip the consideration of all the options. Many people I’ve talked to who have successfully eliminated debt by using the Debt Snowball method not only found themselves back in debt after some time but did not realize that they could have saved hundreds of dollars and been out of debt sooner just by ranking their credit cards in a different order. They simply followed a guru’s advice without any critical thinking. Not only did they not learn to approach money from a more stable viewpoint but they paid extra money in the form of credit card interest for this “feature.”

Would they have succeeded if they were simply presented the idea that they could save money on their debt reduction journey by following a more mathematical approach? It’s certainly possible.

There is no approach that does not have some sort of merit. Getting out of debt in any way possible is better than not getting out of debt at all. All that I ask is that the details, including the total cost and time differences, are fully explained before a method is prescribed for someone else.

Here’s a calculator that will help inform anyone in debt about the timing and bottom-line differences between the various approaches to eliminating debt. In some cases, the cost of one method over the others will be striking.

An informed decision is the best type of decision. With a full understanding of the differences and is familiar with their own psychological tendencies, someone with debt can make an intelligent choice that is right for the individual or family.

Photo credits: House of Sims, Joe Shlabotnik

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Debt Reduction Methods and Philosophies: Snowball, Avalanche and More

Recently, famous finance guru Suze Orman, who usually doles out sensible advice even if in an disrespectful manner, has advised the public to stop paying off credit card debt any faster than minimum payments allow in order to shore up a savings account that could last eight months in an income emergency. According to this recent advice, the economy has changed in such a way that interest payments on debt are small prices to pay for the disaster of a personal recession.

It’s fair to say that Orman has a valid point for some. For example, this advice should be directed to a person whose income depends on a job from which he or she might be soon laid off, if that job is in an industry in which it will be difficult to find a new job, and if he or she won’t settle for a lesser job in while searching for a full replacement. But that describes only a small sample of the population. Orman is painting the picture with too broad a brush.

Liz Pulliam Weston recently pointed out this disagreement with Suze Orman. Weston points out that paying only the minimum to credit cards identifies you as a risky customer. Risky customers are punished by credit card issuers with increased rates and lowered credit limits, in some cases, without advance notice. Besides the direct effect of less available credit and higher interest payments, these actions have an unfortunate downstream effect. It is likely that this will result in a lower credit score.

Again unfortunately, much of modern society relies on a credit score. Your credit is checked when you apply for a loan or mortgage. But it is also checked when insurance companies determine your rates. Auto insurers have found that low credit scores, or credit risk in general, correlates to a risk of dangerous driving. Therefore the insurers feel justified in charging customers with lower credit scores higher premiums for the same coverage. Some employers check credit reports and scores to determine whether hiring you may present an undue risk to the company. And landlords check credit reports and scores when deciding whether you are fit to lease an apartment.

It’s very difficult to function in modern society without a credit history, and a good credit score and clean report goes a long way to make sure you can operate and navigate through life smoothly. Suze Orman’s advice might put that at risk in exchange for an oversize emergency fund in an environment in which the interest you can earn on savings is very low. It could take years to build up eight months’ worth of expenses in cash reserves, and paying only the minimum towards credit cards during that time will prolong and increase the cost of debt. If the minimum payments don’t even cover the amount of new interest charged, by following Suze Orman’s advice, you would be condemning yourself to a life controlled by debt and the credit card companies.

Suze Orman’s advice might be sensible for some people, but it’s important to think about the consequences of all but abandoning the elimination of debt. Where do you stand on Suze Orman’s advice to forgo debt repayment in favor of an eight-month emergency fund?

A Change in Credit Card Strategy, Suze Orman, March 1, 2009
Bad advice from Suze Orman, Liz Pulliam Weston, MSN Money, April 23, 2009

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Suze Orman Says Stop Paying Off Debt

I will admit that the title of this post is a bit inflammatory. I should specify that the more accurate number one frugality tip should be “Don’t be a woman (or a man, but in our society, mostly a woman) obsessed with beauty.” Newsweek illustrates this by breaking down the cost of female beauty maintenance over a lifetime in a recent article, linked below.

According to the study, the average “modern diva” will spend over $200,000 on hair alone. Add in the expenses for maintaining a beautiful face, body, hands and feet, and the average lifetime expense climbs to almost $450,000.

The Newsweek editors go into further detail by splitting the expense by age group. The graphic below shows how much a woman will spend throughout her “tweens”.

Now, I don’t judge. If you have the money to spend, spend it. But it’s better to be conscious about these costs than to let them go by without thinking about them.

The Newsweek study doesn’t go far enough, however. While they’ve provided details about the expenses, they haven’t studied the effect that spending money on beauty will have on a woman’s income or other levels of success. For example, one theoretical possibility is that a lifetime expense of $450,000 for conforming yourself to what the rest of the world considers “beautiful” will result in a lifetime increase of income of $1,000,000. If that is the case, it would be hard to argue than the price of beauty was not well spent.

And in real life, return on investment (ROI) is measured in other ways than money. If for whatever reason, spending money to fit into a certain category makes a person happier, and she can’t find happiness by any other means, how can you argue against spending the money if it is available? If the money is not available, and our diva relies on debt to finance vanity, the true cost out of the pocket could be much greater.

According to the survey’s methodolody, invasive procedures like breast implants and liposuction were not considered in the totals. You can view the raw data here or view the Newsweek story that offers a browsable interface.

Any divas out there? Can you cut back on spending on beauty or is it a justified expense?

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Number One Frugality Tip: Don’t Be a Woman

A few months short of five years ago, I purchased a new 2004 Honda Civic to replace a failing older model that had not been in my care. Today, this “new” car is passing 100,000 miles on the odometer, and it’s still running great. While I occasionally find my mind wandering towards the purchase of something sportier, at this time, I plan on sticking with the Civic until maintenance costs more than the car is worth. I hope to stretch ownership for another 100,000 miles.

Here are the expenses I’ve put into the car so far:

The main accessory I purchased was a lower-end GPS device, which was ultimately stolen from the car while it was parked for the weekend in a particularly bad parking space in Queens, New York. I never replaced the device. The next most expensive accessory was a replacement stereo that fully integrated with my iPod. The service category includes regularly scheduled maintenance as well as a slew of oil changes. It also includes my $500 deductible after a “minor” accident, a tire replacement after one was punctured and unrepairable, and a couple of traffic tickets.

I paid off my non-industry auto loan with an interest rate of 2% somewhat quicker to keep my total interest expense down to $413. Also, according to edmunds.com, my car has depreciated a total of $7,580 since it was purchased.

Many of the expenses should be controlled better, and it may be time to re-evaluate my insurance coverage.

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Passing 100,000 Miles on My Honda Civic

Occasionally, readers email me with questions about their own personal finances. Considering I share so much of my own, it’s always interesting to get a peek into the issues other people are concerned about. In fact, right now, I am actively seeking reader questions to serve as launching points for a discussion I plan to have with Ramit from I Will Teach You to Be Rich.

I always remind people that I am not a financial professional, and whenever seeking free advice, you get what you pay for. But that doesn’t mean I can’t have some opinions or thoughts, and by sharing questions with Consumerism Commentary readers, we can usually come up with some good suggestions.

Here is the latest question I received, from Gerry:

I currently have two rather large students loan. One at $30,000 (4.5%) and one at $15,000 (2.5%). I pay about $300/month towards the larger one and $125/month towards the smaller one.

I was wondering if any bank might ever offer a 6 month or 12 month loan at a lower interest rate. Could I take a $2,000 or $3,000 loan and throw it at the larger loan and pay the bank back instead. Would this even make sense for me?

Note: I am also in school, so my loans are in deferment, but I still make the above payments.

The reader is off to a great financial start by beginning to pay off deferred student loans while still in college. In most cases, students do not need to begin paying off student loans until six months after they end their enrollment (preferrably at graduation), so this head start will be beneficial when living expenses increase a few years down the road.

It’s hard to find better deals for borrowing than student loans. There is only a low probability of finding a bank that will offer a loan at a lower interest rate than 4.5% to pay off an existing loan. If finding a rate lower than 4.5% is important, I would suggest using your “social capital” and ask for the money from a relative. This is a risky proposition; personal loans can be dangerous for the health of the relationship, so this is an option one should consider carefully.

Students with deferred loans have the flexibility now not to make payments if they are causing a financial strain. I would consider taking advantage of that flexibility when it is available. While it’s admirable to pay off the loans early — no debt is “good” debt — student loans are deferred because it allows students to focus on their education rather than trying to find work to create an income.

Am I off the mark? What advice would you give Gerry?

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Reader Question: Find Better Loan to Pay Off Student Loan?

Taking the first few steps to ensure your future financial stability can be daunting. There is so much to do, trying to decide where to start can result in wasted time, and wasted time is wasted money. Eliminating debt is often the first priority, and rightly so. If debt is in the form of credit cards, interest payments could be a massive drag on finances. Credit card companies love offering low minimum payments because they know that consumers who pay only the minimum, and continue adding more debt, will be customers for life. How else could the system get away with taking $20,000 from a customer who purchased a computer worth $1,500?

If you are spending less than you earn, you have the capacity to divert your excess income to long-term savings, debt payments, and an emergency fund. You probably have a desire to put all of you excess income towards reducing that debt, and that’s understandable. Mathematically, that makes the most sense. Credit card interest could accrue at an annual rate of 9.9%, 14.9%, 29.9%, or even worse. It’s highly unlikely that your money can earn that much in any other safe investment over the long term, so paying off debt gives you the most bang for your buck. It’s simple math.

Simple math doesn’t always have the answer when it comes to your money. No, I am not advocating taking emotions into account. Doing what “feels right” isn’t the best option here. But the point is that there are more mathematics to weigh than just interest rates, and it’s the type of math that you can’t plug into online debt payment calculators.

I’ll explain. By diverting all of your excess money to debt repayment without beefing up your savings, you are taking a risk. You are betting that nothing will cause you to incur more debt during the payoff process. Even though your money in a savings account will not earn as much as the amount you’ll save by paying off debt, you have to take into account “known unknowns” and “unknown unknowns.” As the chief financial officer (CFO) of your own life, you have to manage that risj in addition to counting dollars and cents in the bank.

People in corporations get paid lots of money to perform risk management, and if the current financial crisis teaches us anything, it’s that risk managers don’t always do their job perfectly. It is difficult when dealing with issues facing large corporations and industry leaders, but for most people who deal only with loans, credit card debt, future expenses, and investments, risk management can be boiled to its most basic form: have an emergency fund. How can this be applied to paying off debt? Is the emergency fund more important?

If you direct all your excess money to paying off debt, you are likely to fall back into debt the moment an emergency arises. If your water heater breaks and all your money has been directed to your credit cards, you will have to use a credit card again to pay for the repair. You’ve taken one step forward, but now you’re forced to take two, three or four steps backward.

My suggestion is to balance building an emergency fund with paying off debt. When you are ready to divert your excess income to improving your financial condition, start with defining two goals: pay off all of your debt without acquiring more and build a solid emergency fund, which depending on the economy and the market for your skills, might consist of three months’, six months’ or one year’s worth of expenses. Don’t know your monthly expenses? Track where your money is going first.

Start by funding a base for your emergency fund. Pay the minimum to your credit cards or other debt, don’t accrue new debt, and send any extra money to a high-yield savings account until you’ve built one month’s worth of expenses. This will allow you to mitigate some risk while paying down your debt.

Once you’ve reached a one-month buffer, start sending extra money to your credit card with the highest interest rate. I suggest allocating 75% of your excess funds to this first targeted credit card (using the Debt Avalanche method) and 25% to your emergency fund. Keep sending money to your emergency fund month after month until your savings account cushion reaches the goal set above.

Once that target is reached, 100% of your surplus can be directed towards your highest interest rate card. You can rest easily with the knowledge that even while you’ve dramatically reduced the money you throw away to interest payments, you’re financially protected against a temporary loss of income or the typical emergencies you might face. This is just my opinion; maybe you have some thoughts that might be better. Doing anything is better than doing nothing. Do what works for you, if you’ve educated yourself.

Got questions? I (Flexo) and Ramit from I Will Teach You to be Rich are teaming up to answer all of your questions about money. Ask us questions today!

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Which Comes First: Paying Off Debt or Starting Emergency Fund?

Occasionally, Consumerism Commentary readers email me with financial questions. If you want to see a topic discussed here, you can do this as well. Just email me at flexo or tips at this domain name. I can’t answer every email personally, but I’ll do my best to connect you with the resources you need.

Last week, I received this question from Justin about auto loan refinancing:

I’m interested in refinancing my car loan. I was younger and dumber when I bought my car, so I didn’t pay much attention to the financing side of it. I am currently in a 11.96%, 72-month loan, and I’ve knocked off about 2 years so far. I have good credit so I know I could get a better loan. Do you at least have some tips for me as to where to start looking?

With good credit, you should definitely be able to find a better deal, saving you hundreds if not thousands of dollars over the course of the loan. My first inclination is to check BankRate for a comparison of rates for auto refinance loans. Interestingly, the only loan available through BankRate for my location was a 36-month loan through a lender called “up2drive” for 6.90%. I am not convinced that BankRate is providing me with a full picture of what might be available.

I would start with the local banks with whom I already have a relationship. For me, this would consist of Wachovia and TD Bank, but if you are a member or could become a member of a credit union, they often can provide deals you may not find from a traditional bank.

If you’re interested in comparing refinance options to determine how much you might save through the course of the loan, take a look at this calculator. It is designed for home mortgages but the calculation is the same for auto loans.

When you do refinance, unless you choose a shorter period than your original loan, you’ll be extending the total number of payments you’ll make, although those payments will be smaller. I would suggest, if possible, to pay more than your monthly amount if the terms of your new loan don’t penalize you for doing so. To make the most of the money you spend on cars,, pay off the loan as soon as possible and keep the car as long as possible. Don’t feel that you need to buy a new (or new-to-you) car once you stop sending monthly payments to the bank.

I have never refinanced an auto loan. I’ve had loans on two cars at different times, both Honda Civics. The first I sold when I no longer needed a car for work, and used the proceeds to pay off the loan. The second was financed outside of the banking system at a low rate at 2%. This was a loan with a family member, a situation that led me to go outside a strict debt avalanche system and pay off the debt as soon as possible.

I would welcome additional comments and suggestions from readers who have experience with auto loan refinancing or who have thoughts to share on the topic.

Photo credit: tomsaint11

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Tips for Auto Loan Refinancing, Add Yours

Neither a borrower nor a lender be;
For loan oft loses both itself and friend,
And borrowing dulls the edge of husbandry.

That’s a well-known quotation from William Shakespeare’s Hamlet. Polonius was perhaps concerned about, among other things, the public shame that could come from being a deadbeat borrower. As he proferred this and other advice to his son, Polonius may have been thinking about the possibility of seeing Laërtes’ name listed on uradeadbeat.com (read: you are a deadbeat dot com).

Uradeadbeat.com lets anyone post messages and stories about a company or person who owes money. In addition to the public listing on the website, uradeadbeat.com provides a direct service. They will email the deadbeat to inform them of the listing. If you provide an address, the website will also send a postcard.

All deadbeats have a chance to respond to the accusation. According to the site owner, some deadbeats were inspired to pay back their debts as a result of this public shaming.

It’s free to post a complaint, but in the future it will not be a free service.

This probably isn’t the best way to get someone who owes you money to pay up, but it might be a good option as a last resort.

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Publicly Shame a Deadbeat

For several years, interest rates on high-yield savings accounts were high enough to justify choosing to leave extra money in savings accounts rather than using that money to pay off certain debts faster. I was paying only the minimum payment on my consolidated student loan. The loan’s interest rate was 4.25% and I had been earning a little more than that in savings after taxes.

At that time, there was no urgency to pay off the low-interest debt, but the financial climate started to change at the end of last year. Interest available on high-yield savings accounts began to dwindle. By the end of 2007, I decided to eliminate my student loan, my only debt, by the end of 2008. At that time, I had about $13,000 remaining on the loan and had been making payments of my minimum, less than $150, each month.

I had enough cash available at that time to write one check for the $13,000 to eliminate the loan entirely, but I decided it was important for me to keep cash in the bank for flexibility. In January, February, and March, I doubled my monthly payment to $250 to cover interest and principal. In April and May, I paid $500 towards the student loan. For the rest of 2008, I continued to increase my payments through September. In October, with about $6,300 left on the loan, I directed half of the remaining balance to the student loan, leaving about $3,150. I again sliced the remaining debt in half in November.

On Friday, I paid off the remaining $1,500. The payment has cleared today, so I am officially out of debt.

At least for the time being.

If I’ve learned anything from television and other debt-focused blogs it is that I should be jumping up and down with excitement. The fight against debt is often a struggle, especially when that debt is acquired through poor choices. But I feel mostly ambivalent about the achievement. It has helped that I’m earning more than just my day job salary, and thanks to this extra income, I did not have to sacrifice much in order to achieve my target of paying off this debt by the end of 2008. Unlike many struggling with debt, my pursuit is not due to excessive spending. My treatment of debt was not perfect, however.

I graduated in January 1998, but by August 2003, I still had about $4,000 left of my undergraduate student loan. In 2003, I decided to pursue a master’s degree in business. 90% of the tuition (and 0% of the additional fees) would be covered by my employer. Rather than having the company pay the university directly, I allowed the school’s financial aid adviser to convince me to open a loan and use my company’s reimbursements to pay back that loan.

With a long-term view, it was a poor decision. I wonder if the university’s financial aid adviser is instructed to suggest the loan even when expenses are reimbursed because the university makes more money with that option.

With a short-term view, it may have been necessary. At the time, I was not earning much money outside of my day job — my blogging activities didn’t begin earning money until 2004 — and my level of expenses dangerously approached my level of income on a regular basis.

Rather than using my reimbursements to repay the loan, I occasionally deposited the checks into my checking or savings account, allowing the loan to grow. If I had skipped the loan option and decided to have the company pay the school directly, I would have had a tough time with my cash flow for a few years but I might have paid off my remaining student loan much quicker.

As I mentioned, this state of being debt-free is likely only temporary. I do not have a mortgage. I’ve been a renter as long as I’ve been living on my own, and I expect I will continue to rent until I make some decisions about where to live in a more permanent state of being. I expect that I will, at some point, own a house and require financing. Perhaps the feeling of euphoria and excitement that seems to be associated with debt elimination will come once I’ve acquired and conquered a mortgage.

Those who have been following Consumerism Commentary may remember that I also had a car loan. In 2004, I purchased a new Honda Civic — the price differential between “new” and “acceptably used” was negligible — and opted to finance most of the purchase. A loan from family helped me stay away from high interest rates and fees. I paid this loan off within three years.

According to the government, for the first time ever, American household debt has decreased since the same figure was measured three months ago. Don’t get too excited. Americans aren’t suddenly becoming more financially secure. Over the past few months, credit has been harder to come by. Thanks to the state of the economy, car loans, mortgages, and other types of financing for large purchases have been less available. But perhaps there are more people like me who used this year’s declining benefit of savings account interest as an opportunity to pay off debt.

Photo credit: mudpig

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I am Debt Free as of Today!

Debt is like indentured servitude. You work and earn income, but you hand over that income to someone else. With debt, your finances are controlled by someone else, not you. For example, credit card companies have the right to change your interest rate at almost any time with advance notice. In fact, CitiGroup recently raised its interest rates on a wide swath of customers to help bring in more money to this failing company. High interest rates cause customers to take longer to get out of debt because a smaller percentage of their payments goes towards the principal balance. In this case, CitiGroup is controlling a portion of your finances. If a Citi customer is accruing more debt on the credit card at the same time, CitiGroup’s control outweighs the customer’s.

Credit cards aren’t the only forms of debt. Mortgages and student loans prevent people from saving as much money as possible, so even before you make decisions about life goals, it’s a good idea to start eliminating these debt as well.

Good debt versus bad debt

One comment you may hear is that mortgages and student loans are “good debt” while credit cards and car loans are “bad debt.” The philosophy here is that houses appreciate in value, so mortgages provide “leverage,” allowing you to risk less of your own money for a greater return. Similarly, a college education allows you to earn more money in the future. In reality, houses do not always appreciate in value, especially if you consider how house-related expenses contribute to the true cost of owning a home. Also, not everyone earns more with a college degree than they would without one, but on average, those who do earn more over their lifetime. It is possible, however, to earn a college degree without going into debt.

On an individual level, you can’t use generic labels like “good debt” and “bad debt.” If you are accumulating more debt, all debt is bad. If your debt is not increasing, you have the option of weighing your debt to determine which to pay off quicker. For example, at one point, it was common to have student loans with interest rates under 3%. At the same time, high-yield savings accounts paid over 4%. Even after taxes, it was worthwhile — if the student loan was the only debt — to put extra money in savings while making only the minimum payment towards the student loan. That is not always the case, particularly now that savings interest rates are lower and student loan rates are higher.

Now just get out of debt

Getting out of debt is a six-step process, with one extra preliminary step.

0. Put $1,000 aside. You should be spending less than you earn by now, so you have excess income at the end of every month. Start putting aside some money for emergencies even before you start paying off debt. $1,000 is a good target, but you shouldn’t wait until you reach that point before moving on to the next step. The purpose of this money, which will eventually become your “Emergency Fund,” is to allow you to dip into the savings if a problem comes up. Rather than paying for the surprise expense with a credit card, you have a little accumulation set aside. If you already have a savings account set aside for this type of expense, move right to Step 1.

1. Commit to avoiding new debt. You’ve already committed to taking action to take control of your finances, but in order to do that, you must eliminate your debt. While you have debt, you don’t get to use a portion of the income you earned. You already used income you didn’t have, allowed someone else (a lender or a credit card company) to cover the expense for you, and now they own you (or part of your income). Until this relationship is eliminated, do not accumulate more debt. Do not spend more than you earn by using credit cards. Don’t buy a new car if you don’t have the savings. Once you’re out of debt, you can carefully ease these restrictions, but the object is not not get into debt while you’re going through a process of elimination.

2. Call your creditors. There is no harm in calling the credit card companies to ask for lower rates. The customer service phone number is always printed on the back of credit cards, and this is your first point of contact. Historically, people have had success calling customer service and asking for a lower rate. With the economy deteriorating and many banks and credit card companies struggling, it might be tougher to get them to budge on your interest rates. If at first you don’t succeed, ask for a supervisor. Call back, if you have to. In some cases, the banks will offer to lower your rate if you close your card. That means you will pay less to get out of debt and you’ll be restricted from using that card for more purchases. Take the deal! You won’t be using your credit card again until you’re out of debt, anyway.

3. Choose how to pay back your debts. If you want to spend the least amount of money and least amount of time to pay back all your debts, there is only one option: the Debt Avalanche. It’s kind of like Dave Ramsey’s “Debt Snowball” on steroids. The main difference is that the “Debt Snowball” relies on extrinsic motivation while the Debt Avalanche works the best with intrinsic motivation. If you’ve been following the Take Control of Your Finances series on Consumerism Commentary, and you’re committed to the idea of being in control, you have the intrinsic motivation to use the best option.

The Debt Avalanche specifies that your debts should be listed from top to bottom, sorted by interest rate, with the debt with the highest interest rate on top. The balance is not important. To all your debts on the list, pay the minimum monthly payment, but to the debt on top, pay more than the minimum payment — as much as you have available. If your monthly excess income does not meet the minimum payment requirements across all cards, you will have to call your credit card companies to renegotiate. If you aren’t able to make at least the minimum payments, you may be accruing more debt without spending anything. It’s like a cruel magic trick.

This method works best when “all debts are created equal,” for example, when all debts are credit cards. But it doesn’t always work that way. You may have a loan from a family member. Maintaining good relationships with your family should be a larger goal in life, outside of money. You may want to pay this debt off first, even if the rate is 3% while your credit cards are at 14.9%. This decision is a personal choice. If you decide to pay the loan off faster than your credit cards, move this loan to the top of the list. Pay your minimums to all other debts, but to the loan at the top of the list, pay as much as possible.

Once the debt at the top of the list is eliminated, do a little dance if you are so inclined, cross out the debt, and start putting your excess money towards the debt that is listed second. Remember, try not to accumulate new debt during this process.

4. Automate your payments. If you can have your credit cards deduct your payments directly from your checking account automatically, this is a great way to eliminate the possibility of human error from the process. Some credit card companies won’t allow you to do this. It would guarantee that your payments would always be on time, and the credit card companies would lose out on possible late fees and finance charges. Even if that is the case, visit your credit cards’ websites and link your checking account. This way you can pay your minimum or more with one click rather than writing a check, finding a stamp, and remembering to drop your payment in the mailbox.

5. Get in the groove. People get into debt for different reasons. Some people like shopping to buy new things. Some people have an addiction. Others are faced with an emergency with no other options that credit card. Occasionally, people make bad choices. Whatever the reason, see what you can do about changing your behavior. Creditors make it easy to stay in debt, and it’s difficult to see the consequences of debt accumulation. If you’re tracking your money, you have a good indication of the effect debt has on your net worth, and you’re able to predict the state of your finances in the future.

The more you’d like to do with your life down the road, the more money you’ll need. Debt, in all forms, works against you. Get in the habit of making good decisions about your money and spending less than you earn.

6. Complete your payoff. Getting out of debt fully calls for a celebration. It may take decades to do so, especially if you have a mortgage. Celebrate however you may like, but don’t fall back into debt.

Photo credit: quaziephoto

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Take Control of Your Finances Part 6: Get Out of Debt

I’ve been naughty.

I went a little nuts a few weeks ago and bought a whole bunch of audio/visual equipment. I didn’t do this just for fun, though. It’ll probably end up looking like an investment someday.

I got a mixer and a bunch of microphones that we’re going to use to create alternative movie commentaries. The commentary tracks will be for sale, but of course there’s no way of knowing whether it’ll be profitable. I tried to find a cheap way of doing this, but the sound quality would’ve suffered. For what it’s worth, I did buy the “scratch n’ dent” mixer for $40 less than it would’ve been. And the microphones were a good value. You can pay hundreds of dollars for a good microphone, but I found mine for $50. Of course, I bought three of them, so… Also, I needed a pop filter and a desk stand for each of them. Those weren’t free.

Since I had already decided to be naughty, I also bought a new video camera. I already had one that provided a pretty good quality image, but the sound was just awful. It’s a small consolation, but I sold the old camera for $90 to help pay for the new one, which was about $650.

All of this went on a credit card, of course. That’s why I say I’ve been naughty. I didn’t pay for it up front with money that I’d saved.

But you know what? My friends and I got together this past weekend to record our first commentary, and we had a lot of fun. Maybe the novelty will wear off, maybe it won’t, but I’m starting to think that it wasn’t quite so naughty, after all.

In other news, I accepted a job offer at a new place that will be paying me a little over $9,000 more per year than my current employer. I figure that should mean an additional $600 per month, so my credit card debt will be paid off even faster. More importantly, I think I will love working at the new place. Aside from the work itself (Information Architecture, Usability) which I have a lot of fun with, I had a couple of extended interviews with some of my future co-workers, and I think we’ll get along great.

Naturally, Apple came out with updated notebook computers yesterday, and I’m thinking of upgrading…

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Smithee Update: October 2008

When it comes to mathematics, certain facts are universally agreed-upon. For example, regardless of your culture or educational system, you must agree that one plus one equals two unless you mistakenly fall for an invalid proof. When dealing with money, why are people inclined to believe that one plus one does not equal two?

If you have a certain amount of money available to pay off a portion of your debt each month, even if that certain amount changes, there is a mathematically correct way of paying off that debt. You can call this approach the Debt Avalanche. It is similar to Dave Ramsey’s popular “debt snowball” method, with one small but important detail: With the Debt Avalanche you will pay off your debt faster and pay less total interest to banks and lenders.

The simple calculation for the Debt Avalanche requires only the interest rates for each debt account. This assumes that all debt accounts have the same tax liability, but if that’s not the case, determine your interest rate after taxes for this calculation.

Step 1. Order your debts from highest interest rate to lowest. You may find credit cards at the top of the list. It’s typical to see interest rates from 10% to 20% or more. Credit cards offered by stores often have the highest interest rates, so you might find these at the very top. Watch out for promotional rates ending, which they may do on the date promised when you enrolled, or earlier. Card issuers also re-evaluate their customers every so often, and will not think twice about raising your rates midstream. Note that if your credit improves, they will not magically lower your rates. While lenders will notify you if they intend to raise your rates, you may have missed the notice.

Your mortgage and home equity loan may be the next debts in line. It’s important for your list to capture every debt for which you make a monthly payment. Student loans may be the last on the list, particularly if you qualify for tax credits. The Debt Avalanche formula won’t work properly if it covers only a portion of your debt, so consider all accounts.

Order your list from the highest interest rate (after tax) to the lowest. You may have noticed we didn’t factor in your account balances in the above formula. That is because your individual account balances are irrelevant. The issue solved by the Debt Avalanche is the best way to pay off your total debt with all available funds.

Step 2. Pay the minimum to all debts every month. If you’re writing down your list, or using a spreadsheet like Excel, add a column next to each debt to list its minimum monthly payment. This is the amount you will pay towards each debt, except for the one account listed at the top of the list.

Another column should list the payment due date if it is relatively static from month to month. For example, my credit card payment is due on the last date of almost every month, so I would write “30.” This would indicate to me the last date of every month. Your payments should always arrive before the due date. In fact, in some cases, you can reduce your total interest paid by paying weeks in advance of your due date.

Step 3. To your debt with the highest interest, send all extra available cash. If you have an emergency fund, this step is simple. Since it’s unlikely that you can earn more in savings than you can “earn” (reclaim) by paying off your debt, all your unused income after paying expenses (necessary and discretionary as you see fit) should be dedicated towards the debt account with the highest interest rate.

Step 4. Repeat every month. You cover all your bases by ensuring every creditor receives the minimum payment, but you hone in on only your debt with the highest interest. Once a debt account has been eliminated — and it may not be the account at the top of the list if other balances are smaller — remove it from the list and re-order if interest rates have changed.

It’s that simple. This is mathematically the best method for paying off your personal debt. No other method will get you out of debt faster and save you as much money.

Despite the facts, many people disagree. The primary reason detractors, or supporters of the “debt snowball” method, may argue is that Dave Ramsey’s method will help you pay off your smaller debt faster, providing you with “early success” and possibly the motivation to continue along the path of debt reduction. The Debt Avalanche will also provide early success, but if you need special motivation to continue your monthly payments, consider this: By choosing the Debt Avalanche method, you will pay off your total debt faster, you will pay less interest, and you are mathematically efficient.

That is motivation enough. Or is it?

Dave Ramsey believes his “debt snowball” method, in which debts are paid off in the order of balance from lowest to highest, has shown better results than any other method thanks to “quick wins.” If he were to ask his followers if they want to carry their debt longer and pay more interest throughout before offering the “debt snowball” method, they would choose the faster, cheaper, better option of the Debt Avalanche.

One of the many reasons people can fall into debt is the difficulty of separating emotional thinking from rational thinking. The Debt Avalanche helps separate these two methods of thinking, as the best financial decisions are almost always the rational decisions. But it helps to pay attention to some of the psychology involved, as well.

The possible motivation due to the “early success” aspect of the debt snowball method is cited by many followers to be its strongest point, encouraging debt reducers to continue down the path. Followers of the mathematically and financially superior Debt Avalanche, if they need this sort of motivation, can achieve the same effect by defining milestones.

Rather than “celebrating” when your first full credit card or other debt account is paid off, take note and reward yourself when you’ve paid off your first $1,000 (or $500 or $10,000, whatever is applicable to you). Setting and achieving these short term goals influences the same area of the brain (the mesolimbic system) as the act of paying off the first credit card and are similar enough to provide the same motivational results.

Quick wins may help to motivate debt reducers to continue along the path, but the real win comes in knowing you’ve made the smarter choice.

Updated on July 8, 2008 with more information about redefining milestones to address the psychological effect of “quick wins.”

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The Correct Way to Pay Off Personal Debt: The Debt Avalanche

If you have variable rate student loans, mark July 1, 2008 on your calendar. After that date, you can lock in interest rates 3 percentage points lower than what’s available now. I’m not eligible for lowering the rates on my student loans because I’ve already consolidated and I have no new student loans to add into the mix. But if you haven’t consolidated yet, you may be able to benefit from rates as low as 3.62%.

I have about $11,000 left to pay on my student loans at 4.25%. As savings interest rates have decreased recently, I’ve been increasing the amount I’ve been paying to eliminate this debt. This loan is the only debt I have that requires interest payments, and I’ll be happy to pay it off.

Earlier this month I sent $750 to student loan repayment. That payment is up from $500 the month before, $250 earlier this year, and about $150 earlier than that. In July, I’ll either maintain my $750 payment or increase the amount to $1,000 depending on my June financial results.

Update! There are a lot of questions being asked already, so here are some details.

• Since many lenders no longer perform student loan consolidation, you may be better off starting your search with the U.S. Department of Education who will.
• Only variable-rate student loans are eligible. All student loans initiated after July 1, 2006 are fixed-rate loans, so these loans will not qualify for the lower interest rate, but you can still consolidate multiple loans to reduce your number of payments, your minimum due, and extend your total repayment duration.
• If you’re still in school, you are not eligible for the lowest rate. If you’re in the six-month grace period, you can receive the lowest interest rate on the loans that are over two years old (usually from your freshman and sophomore years). If you’ve waived your grace period you’ll only qualify for a higher rate.
• If you’ve already consolidated your student loans, you won’t qualify for the lowest rate.

Note: The Department of Education’s loan consolidation application will not indicate the new, low interest rate until July 1. Consolidation applications are on hold until that time.

3.6% student loans: Consolidate now, Liz Pulliam Weston, MSN Money, June 23, 2008.

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Get Ready to Consolidate Your Student Loans

A new study by researchers at Vanderbilt University Law School and University of Oxford reveals a strong correlation between approvals for payday loans and bankruptcy filings. Considering that people who are rejected for payday loans have other (limited) options for credit, it’s surprising that the rate of bankruptcy isn’t as high with this group. It’s quite possible that this can be interpreted as a cause-and-effect relationship. That is, being approved for payday loans increases the probability of filing bankruptcy.

Individuals who have been approved for payday loans have a probability of filing for bankruptcy within two years 2.48 percentage points higher than the probability for individuals who were rejected for payday loans.

It sounds obvious, but scientific findings that payday loans contribute to bankruptcy confirm any hunches. Payday loans a short-term loans with fees which, if viewed in terms of interest rates, are very high. Rates of 100% APR or higher are common. The loans are designed to be paid back in two weeks, however, so you only see a 100% interest rate if you roll over from one loan to the next for an entire year.

Most people who have the need to get cash quickly in the form of a payday loan don’t continue the cycle continuously for a year, but many do become repeat customers. The typical payday loan borrower will apply for about five more payday loans totalling over $1,500 within one year after the initial acceptance.

The study shows that interest from payday loans accounts for about 11% of the a bankrupty filer’s total interest burden, and this 11% could be what finally pushes an individual into declaring bankruptcy — the proverbial straw.

These results are consistent with the interpretation that payday loan applicants are financially
stressed; first-time loan approval precedes significant additional high interest rate borrowing; and
the consequent interest burden tips households into bankruptcy.

The authors of the research discount the idea that individuals preparing to declare bankruptcy quickly accumulate as much debt as possible to maximize bankruptcy’s “benefit.”

While it’s certainly possible to borrow money through a payday loan, pay the entire balance plus interest when it is due, and never become a payday loan customer again, this is not a typical scenario. Furthermore, those who have low credit scores may be rejected by payday loan companies and turn to pawn loans instead, with similarly high interest rates. Yet, the payday loan customers have the increased incidence of brankrupcty.

Do Payday Loans Cause Bankruptcy? [Paige Marta Skiba, Vanderbilt University Law School and Jeremy Tobacman, University of Oxford]
via Research Recap via pfblogs.org

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Study: Payday Loans Cause More Bankruptcies

This article was written for Consumerism Commentary by Adfecto, a mid-20s guy with a masters degree in engineering. He aspires to be wealthy and writes frequently for his own blog, Adfecto Abundantia.

When I purchased a home it was not a lifetime commitment. I view a person’s choice of housing first as a financial decision and second as a lifestyle decision. A house gives you place to live and the added bonus of potential price appreciation and tax deductions. If it is cheaper to rent then by all means that is the way to go. Owning your own home can also give you a tangible increase in your standard of living, but personally that is considered a distant second when compared to the financial benefits. What I find interesting is that so many people tend to make emotional decisions about the home rather than rational ones.

Frequently, when home owners find themselves with a little extra cash at the end of every month, the idea of paying off the mortgage is often brought up. Is early payment the right way to use the money? Should the money be invested instead? Is my real motivation to build wealth or to play it safe?

The first step in analyzing this decision is to compare the interest rate on the mortgage to expected investment returns. Historically the S&P 500 with dividends reinvested has returned 10.43% annualized from January 1926 to December 2007, and the current rate for a fixed 30 year mortgage is about 5.76% according to www.bankrate.com. Based on this simple comparison it is plain to see that in the long run you will build more wealth by investing than by prepaying your mortgage.

If you want to further hone this comparison of rates, next you can consider not just the entire history of the stock market, but also every 30 year rolling period of stock market data. Since 1953 the S&P 500 has returned at least 9.34% over every 30 year period which is again well above the interest rate for a 30 year mortgage. Plowing your money into prepaying your mortgage has a huge opportunity cost that will hurt your ability to build wealth.

Why then would people consider prepaying their mortgage? Most people consider their home as a safe investment, and paying off a mortgage as a guaranteed return. A certain piece of mind comes from owing the bank less money. There is a big problem with this argument; there is still a great deal of risk involved with your primary residence!

Some of this risk comes from the fact that the value of real estate is not fixed. It absolutely goes both up and down as many people in Florida, California, and all over the country are now experiencing first hand. Every dollar that is put into a residence is not necessarily money you will get back when you sell.

Additional risk comes from the fact that until your loan is paid in full, the bank still holds the mortgage on the property. The bank will not give you credit for the extra payments made to pay down the debt if you start to struggle further down the line. Even if you are way ahead on your mortgage, a hardship may cause you to miss payments. The bank can foreclose even if you spent years paying down the mortgage balance early.

Investing your free cash into your mortgage is very similar to investing in a bond. It may seem odd, but you are literally investing in a fixed income asset, the mortgage, lent to yourself. The return you get will be equal to the interest you would otherwise pay on your mortgage. One problem that arises is that the bank has first crack at the collateral; your house. Even worse, your mortgage isn’t even a very good deal when compared to the types of bonds; for example, Toyota AAA rated bonds currently pay as much as 7.652%. I bet your mortgage rate isn’t that high.

Furthermore, understanding the nature of your mortgage as a bond brings to light another risk; improper asset allocation. Mortgage prepayment shifts your asset allocation to rest more heavily in fixed income type investments than you might otherwise consider. A 40 year old person should have at least 60% but more likely 80% percent of his/her portfolio in stocks, but add in all of that mortgage prepayment in the bond category and you may find yourself far out of line from you ideal asset allocation.

Another risk related to mortgage prepayment is a lack of diversification. You may think that your mortgage is not very risky because you believe in your own ability to pay. This personal bias can cloud a person from see the true risk factors such as job loss, poor real estate conditions, natural disaster, and a plethora of others. A single unfortunate event can wipe out a large chunk of the equity. A single job loss may bring about a short sale or foreclosure that could wipe out the value of your home. Would you advise someone in your circumstances to invest in individual mortgages? I sure wouldn’t, and neither should you.

Deciding whether or not to prepay a mortgage is another financial and lifestyle choice which depends on several factors, but most of all it is a choice between building wealth (logical) and piece of mind (emotional). People who focus on paying off their mortgage seem to be more in love with their house and the idea of having it paid off than the goal of building wealth. These people are also blind to the risks that come from investing too much of their finances in a single residential structure. I think that for the majority of people the ‘right’ decision would be to keep the mortgage and invest the extra money.

Image credit: Oracio
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The Case Against Mortgage Pre-Payment

Countrywide, the country’s largest mortgage lender, is stepping in to “rework” 82,000 loans totaling about $16 billion. I believe that the lenders and the borrowers are both partly to blame for the mess. Lenders offer risky loans, and customers, happy to hear they can afford more than they anticipated, sign up without realizing they can’t really afford it.

When a company like Countrywide gives into consumer pressure, you can be sure other lenders will follow. While this is good for the economy in the short-term and good for the borrowers overall, it may send a bad message. It perpetuates the idea that there are no real consequences to being in debt. Bailouts extend the ability for people to survive while simply signing their paycheck over to other people and companies like mortgage lenders, electric and cable companies, and credit card issuers.

This is a dangerous thought: As long as you are following the spending trends of millions of other people, you are safe. There will always be changes in regulations or laws to keep the economy somewhat afloat, and if you’re representative of the greater economy, chances are you’ll be kept afloat as well.

While history shows that in general that has been the case it is a highly dangerous way of thinking, because it doesn’t play out that way for everyone, and you have no idea of knowing if it will for you. It’s a much better idea to live below your means and never have to worry.

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Countrywide to Bail Out Overextended Borrowers

Ah, student loans. The things that remember you long after you’ve completely forgotten the entire college experience.

Although I finished college in 1997 and graduate school in 2000, loan payments to Sallie Mae have been a constant fixture ever since, like a little wound I’d nurse which just wouldn’t stop bleeding.

Even when making double or triple monthly payments, the amount I owed hardly seemed to diminish at all. I set up direct deposit, did everything I could to nudge that low interest rate down even further, and eventually consolidated my loans, but I was still frustrated, unable to see that light at the end of the tunnel.

Perhaps this was because (and I’m actually facing this number in its entirety for the first time ever right now): that tunnel was pretty darned long. $52,050.74 long. Looking at it actually makes me feel faint.

And that’s just the principal – that number doesn’t even take the interest payments into account. I’m afraid to figure that total out.

I won’t say for a second that my higher education wasn’t worth it – it was just a bit of a hard road to travel, despite my high level of motivation and desire to be self-sufficient. My parents either couldn’t (Mom) or didn’t (Dad) contribute to my college education, so I waited tables like crazy throughout highschool, washed dishes for a whopping $4.50 an hour within the work study program once at college, and got student loans, both subsidized and unsubsidized, to cover the rest.

I still wasn’t anywhere near paying off the 4 years of undergrad study when, after several years in the workforce making double loan payments each month, I decided to go to graduate school. Another $18,000 added to the sum, and that’s because I chose to complete my Masters degree overseas, where it was cheaper.

That loan amount kept swelling like an engorged tick, but because it was in a flurry of separate disbursements, I never really faced the total, just a few thousand here and ten more thousand there. My interest rates were pretty good, so I’d just been paying it down monthly ever since, hoping one day to reach the elusive endpoint.

Last year, I started becoming more financially aware and contributing to my savings account. I was so happy that I had finally amassed some money in savings that was earning 5.25%, but then I noticed that my consolidated student loans were still costing me more than that in interest at a rate of 5.38%. And because of my salary, I don’t get to deduct a single penny of that interest from my taxes.

Because I was just paying under $200 a month, it didn’t seem that bad, but once I really got into crunching the numbers, I realized that I’d been paying around $75 a month in student loan interest, which turned into a big ouch when I looked at the cost annually. And despite all my extra piecemeal payments, nearly ten years later I still owed around $22,000 to my old friend Sallie Mae.

I sought the help of a financial advisor. She explained that although some of my residential and rental property mortgage rates appeared at first to be higher, after tax deductions, my student loans were hands-down the most expensive of all my loans.

Based on her advice, I decided to grab some cash out of my coveted savings account and start hacking away at the remaining loan amount, paying as much as I could whenever I found I had uncommitted funds at my disposal.

My tax refund and all my savings except my emergency fund went right to Sallie Mae, knocking off $10,000 from the total. I moved my emergency fund to a high-yield savings account earning 6% at FNBO Direct, and started funneling every extra penny into that account, elated each time I was able to transfer money in. The interest was a nice bonus, giving me more incentive to store funds at FNBO Direct before surrendering them, never to be seen again. Once there were sufficient funds in the account, I’d do yet another payment to Sallie Mae, $500 or $1000 at a time.

It felt like the wound was hemorrhaging, and I dreamt of having a nice big savings or investment account instead, but I remained committed to reducing that total.

And around 2 months ago, I finally got that total just under $4,000. The end was in sight! I started bringing more lunches, buying less clothing, socking away funds just a little bit more – anything to finish that final lap.

And today, I did it. I sent my final payment of $3,880, and bid my old friend Sallie Mae goodbye with a cheer.

The number was $52,050.74. It was outright terrifying, a giant monster that wouldn’t fit beneath the bed. And as of tomorrow, that number will be zero.

In ten years, I have paid off $52,050.74 in principal, and still more in interest. I say it again because now I like that number; now I’m very, very proud.

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$52,050.74: A Farewell to Student Loans

With the savings rates falling like bricks lately, there is no advantage to me keeping my student loan payments low while keeping my bank account in the stratosphere. My student loan interest rate is 4.25% and I may not qualify for any tax advantages which would otherwise effectively reduce that interest rate. My savings aren’t earning much more in interest, and after income tax, it’s likely less.

I’ve decided to speed up my student loan payments. I’ll end up with less cash on hand in the next few years, at the same time I might be purchasing a house, but the lack of debt will put me in a better position to afford a mortgage.

This week, I sent $5,000 to my student loan.

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Paid Off a Chunk of Debt This Week