Here is week 2 installment of in-house credit analyst Jay Turner’s series, Hot Six for the Summer. Please comment with your questions or you can email him at firstname.lastname@example.org .
Hot Six for the Summer: Balancing Act
In our last Money Monday installment, we discussed the value of knowing your FICO scores and understanding how your scores are calculated. I want to introduce a bit of credit yoga to our routine today and examine your balance – your credit card and loan balance(s).
Pop quiz: What are the current balances on each your debts? While you don’t necessarily need to be able to answer this question off the top of your head down to the penny, I believe you should know these answers at any given time at least to the hundred. Being constantly aware of how much you are indebted to the piper will help you ultimately escape his grasp.
If you recall from last week, we mentioned that payment history constitutes the largest element of a FICO score. Pay on time, even if it is just the minimum amount owed, and your account will report current to the credit bureaus (although you should always pay more than the minimum due if you must carry a balance). I also know that life happens and some of us have late payments in our credit files, which will report to the credit bureaus for seven years after the delinquency. There is not much you can do to alter your payment history; however, if you commit to being consistent in your efforts to pay your debts by their due dates, time will lessen the impact that late payments have on your score.
While you cannot fix your payment history, 35% of your FICO score, you can control the next 30% chunk of your score, the amounts owed. Your disposable income is a finite resource, so it is necessary that you have a strategy when it comes to reducing your balances. Here are a couple of balancing acts that I have used over the years to pay down loan balances, which reduces the amounts owed showing in your credit report, which will in turn help increase your FICO scores. I’m a fan of these approaches, which draw significantly from Dave Ramsey’s Debt Snowball, as they are objective-oriented and each gives you a sense of accomplishment.
Take Out the Little Guy: Grab your most recent loan and credit card statements and make a list of all of your balances, sorted with the lowest first and the highest balance last. Armed with this list, you will eliminate your debts from the least amount owed to the greatest. Pay the monthly minimums on each debt except the smallest, which you’ll pay as much additional principle as your budget allows. Each time you rid yourself of a debt, you take the money you were applying to the eliminated debt and add it to the amount you will pay on your next smallest debt.
For example, I currently have three debts remaining in my credit profile – a mortgage, a small student loan I took out my senior year of undergrad, and a larger student loan I’m repaying from grad school (I have a platoon of credit cards I use for rewards, but I never carry a balance). My wife and I decided several months ago that we would make it a priority to eliminate these last three debts using the Take Out the Little Guy method. As of yesterday, the small student loan is no more, and the remaining loan will be paid off no later than March 2013.
There are two benefits to this strategy. First, you’ve freed up money that you were paying each month for that debt. In my case, the small student loan amounted to $75/month. I’ll take the $75 I was paying on that loan each month and apply it toward knocking out the second, larger student loan. Another benefit is the sense of satisfaction I get when I see a debt balance paid to $0. The momentum renews my fervor for eliminating debt.
Stop Ripping Me a New One: Take a look at your loan and credit card statements and make a list of all of your debts, sorted with the highest interest rate first and lowest interest rate last. With this information in hand, you will tackle your debts by knocking them out from the highest rate to the least. Pay the monthly minimums on each debt except the one with the highest interest rate, which you’ll pay as much additional principle as your budget allows.
Going back to my recent experiences, shortly after my wife and I were married, we found ourselves with a mortgage (5.75%), my wife’s car note (6.8%), and my two student loans (3% and 4.65%) – again, neither of us carries credit card debt. We looked at our debts and clearly saw that her car note carried the highest interest rate, followed by the mortgage, and then my student loans. There was also the pending need for me to get another car, since the 1992 Crown Victoria I owned was falling apart. We committed to living like paupers for a year and paying off the note for new minivan in that 12 month span, and we were successful. We saved more than $2200 in interest by knocking out this loan four years in advanced.
After paying off her van, we bought me a low mileage used car from CarMax. Its interest rate (7.2%) was still the highest in our pecking order, so we decided to live like paupers for however long it took and pay it off as well. Eighteen months later I owned my car outright, saving over $1600 in interest by retiring the loan the 3.5 years early.
The plus to this approach is that it will save you the most money over time, because you are reducing the amount of interest you are paying to the bank. The money that was going to each of our car notes now goes to eliminating other debts and saving toward our retirement.
The two approaches described above allow you to strike a balance between staying current on your loan and credit card payments while also accelerating your trajectory to a debt-free life. There are myriad ways to tame your debt load, but these are two that I feel can work for almost any budget. What strategies do you use to balance your debt load?
Just one of ‘fatboyfavs’