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On Finance: Debt Reduction Math vs. Reality
Now and then someone will ask me what I think about a plan they have to improve their financial situation. Usually they have worked out a logical way to reduce debt, reduce the cost of debt, and/or solve some other specific problem with debt (it is interesting to note that, once acquired, debt seems to consume great deal of people’s thoughts). Typically, after a brief overview I can quickly agree that the approach makes mathematically sense, that it would work as they outlined, but I usually end up not recommending it. For obvious reasons they tend to be confused at my answer. The contradiction in my answer is the result of seeing, time and again, the directions these plans often go.
Most of the approaches involve using money more effectively — which is ideal as it allows us to get ahead without major changes to their lifestyle or budgets. It is logical thinking, and good math, to take money that earns a little interest to pay off debt that has a high interest costs. Similarly it make sense to take a lower interest loan to pay off a higher interest loan. However, when mathematics and reality come together we usually end up with a bigger problem.
Here are a few common, mathematically sound, methods for paying off consumer debt (credit cards, car loans, etc):
HOME EQUITY: Refinance the house and pay off all the debt (or use a home equity line of credit). Use the money that was going for the car and credit card payments, along with the savings from the lower interest, and make extra payments on the mortgage. No more consumer debt and the new mortgage will actually get paid off sooner with the extra payments.
RETIREMENT: Re-direct money that is going to retirement and use it to accelerate payments on consumer debt. Alternatively, borrow money from the retirement account to pay off all the consumer debt. The interest savings, along with the money you normally put into the retirement account, will pay off the debt faster. Once the debt is paid off you can accelerate payments to the retirement account to make up the difference.
MOM AND DAD: Mom and dad have some poorly performing investments for retirement. They can loan money at a fraction of the cost of the car loan, student loan, and credit cars. Even paying them twice what they are currently making will reduce costs enough to pay everything off faster and cheaper. On top of all that there it isn’t reported on my credit reports so I can qualify for a new mortgage (and other loans). Everyone wins.
CAR SWAPPING: Trade in the two year old car with the high interest rate four year loan and buy a new car with the great six year low interest loans being offered by dealers. The savings on the lower monthly payment will allow faster payoffs on the high interest rate credit card debt.
There are quite a few variations with alternative sources available to reduce interest rates or extend payment periods in order to lower cost. They can then redirect the savings to paying things off faster. They all have the mathematically advantage of paying things off faster and at a lower total cost.
The problem is that each of these are TWO step programs: FIRST do this and THEN do that. Invariably the first part is done but things get a little sticky on the second part. This is because the habits and lifestyle which put the individuals into the difficult situation in the first place are not changed.
Doing the first part of each plan solves the immediate problem or crisis. It takes the stress out of the current finances. Not being stressed means they feel more comfortable and confident with their finances. As our government recently stated, feeling comfortable and confident causes people to start spending money again. Having just “paid off” or greatly reduced, actually shifted, the recorded consumer debt it is easy to borrow money again. The next cycle beings….
As happened the first time, a variety of things will come up for using the newly available consumer debt; buying a new car instead of fixing the old one, upgrading the heating system, a new HDTV, taking a well needed family vacation, etc. Soon after these things happen the THEN portion of the equation, the part about paying off the original debt faster, comes to a screeching halt. Eventually they have an entirely new consumer debt problem AND they actually still have the old debt — or the loss of the equity that used to be their safety net.
Believe it or not, t is better to take the harder, more stressful and educating method of paying off the debt instead of taking the easy and, paradoxically, the smarter way out.
IF you can stay to the original plan AND change your lifestyle and habits AND not re-acquire new debt THEN, and ONY THEN, do the plans work. Be forewarned, the odds are against you.
Posted by Paul Gernhardt on Sunday, January 04, 2009