photo credit: millicent bystander

There are many theories on what the best way to pay off your debts is, but before you should even start talking about paying off your debts, you’ll first need to stop the bleeding (accumulating more debts). In order to do that, let’s first discuss good debt, bad debt, secured debt, unsecured debt, and Effective Annual Rates (EAR).

Good debt: This is the stuff that generally results from an investment in yourself (student loans) or something that appreciates in value (house) that will ideally leave you in better economic standing over the long-term. Typically, these debts will carry a lower rate of interest (unless you took out an ARM mortgage).

Bad debt: Any debt that will not benefit you in the least bit, in any way. Most typically, credit card debt, which carries a very high interest rate. 

Secured debt: Debt that you take on that is backed up by collateral (a possession that can be taken from you). This includes a mortgage and a vehicle, for starters. Essentially if you do not make your payments, you may lose the possessions that you purchased via this debt. Due to the fact that nobody wants to lose these things, the borrower has little to zero bargaining power with the creditor. Because there is collateral involved and default is not highly likely, creditors can afford to offer lower long-term interest rates.

Unsecured debt: Debt that has no collateral behind it. This includes credit cards. If you don’t pay off your debts here, you may be harassed by creditors and bill collectors the rest of your life, but they have little power other than ruining your ability to receive secured debt at good rates in the future. That’s important to you, but for the most part this is of little consolation to them if they can’t get their money back.

Creditors that offer unsecured debt charge high interest rates partly because they have little power to do much if you don’t pay them back, and many people will default, declare bankruptcy, or just switch cards. Now, I’m not recommending that you don’t pay off your debts with these guys, but it is important that you realize that you do have a bit of leverage with them. This leverage gives you negotiation power, and we’ll discuss how to use it.

Effective Annual Rate (EAR): Credit card companies will often quote you a nominal APR (annual percentage rate), which is compounded monthly. However, this is usually not what you end up paying. Due to the compounding, you pay more. EAR takes into account the compounding to give you an effective rate that you actually pay on your card. It is important to know the distinction between the two, because you are likely paying more than you think on your card.

Now that we’ve discussed the different terms, let’s discuss the steps you can take to stop the bleeding from debt.

Step 1: Cut your cards

Literally, slice and dice them. If you’re in debt, you’ve lost the privilege to try to use cards to better your financial health. You don’t need them, so stop convincing yourself that you do. An alternate debit card will always pay for the same things that a credit card can, and it’s money that you do have. Or you could even go one step further and use checks or cash. The convenience of not feeling the repercussions of poor spending habits is the biggest barrier to you getting out of debt. Eliminate the convenience and you eliminate a huge part of the problem.

Step 2: Know your debts

I’ve created a simple document for you to keep track of all of your debts, how much you owe, and what you’re paying in interest on each:

Debt Planner Spreadsheet (google doc - feel free to copy and save your own editable version)

debt-planner-spreadsheet1 (.xls/.ods)

Document all of your debts and label them as good or bad based on the descriptions above. If you don’t know the EAR on your debts, substitute APR, but realize that APR is almost always less than what you are truly paying.

Step 3: Pay less on your bad debts

Here is where your leveraging power comes into play. Your worst type of debts are going to usually be your credit cards which are also unsecured debts. Because credit card debt is unsecured and you are free to switch to any other credit card company and transfer your balance, you have leveraging power. I would suggest calling up every credit card company that you have a balance with and asking for a better rate.

My recommendation is to do some research and see what other card companies are offering for non-introductory rates. This will give you ammunition if your existing company won’t match or beat their rates, or at least it will give you realistic expectations on what you can get. You don’t really want to switch companies because it will give your credit report one more black mark (ending your long term account, and starting a new one).

Here are a few places to compare rates on credit cards (don’t apply, just bargain hunt for leverage!):

bankrate.com

cardtrak.com

I was able to find a number of cards that had a permanent rate of under 11%, and many had 0% introductory rates for the first year. Some had low single digit rates on balance transfers. This is all good negotiation leverage. Let’s say you are currently paying 18%, you could have the following conversation with your card company (as with any negotiation, it pays to be congenial and cooperative with them versus combative):

You: Hello, Mr(s). credit card customer service representative. I am having trouble paying off my balance as fast as I’d like and an 18% APR is way too high for me. I’ve been doing some comparative shopping for better rates and have found a few balance transfer cards that will give me a 0% introductory rate for the first year and then 10%, thereafter. I’ve enjoyed being your customer, so I would hate to switch, and I wanted to ask you to match that permanent rate of 10%.

CSR: Well, Mr. Bad Debt, our rate is competitive with the industry, but let me check to see if I can make a special offer.

<long pause>

CSR: It turns out that we can offer you 12%. How does that sound?

You: I appreciate the offer, but I literally would be able to switch tonight to (reference different card company) and get a permanent 10% rate.

CSR: I will need to check with my supervisor to see what we can do. One moment please.

You: Great, thank you.

CSR: OK, I checked with my supervisor, and we are able to offer you 10.5%.

You: OK, that is enough for me to stay with you for now.

<actual conversation may vary>

Step 4: Balance your budget by spending less than your disposable income

Check out these posts on using a personal budget planner spreadsheet and learn how to balance your monthly budget to see all of your monthly expenses and figure out where to cut back. Your first step should be to eliminate all unnecessary monthly expenses so that your card balances don’t keep snowballing with new debts (your interest snowball is going to be tough enough to overcome). If you’re still spending more than you make then you’re going to have to either A. make more money, or, B. cut your expenses. Usually the latter is easier. It all comes down to living within your means. Here is a free personal budget planner spreadsheet to help you out:

personal budget planner spreadsheet (google doc, feel free to copy and save your own version)

20somethingfinancecom-personal-budget-planner (.xls/.ods)

Next time we discuss getting out of debt and staying out of debt we’ll tackle the issue of paying off your debts.

But for now, I have a few questions for you:

a. what tactics have you found to be helpful in stopping new debts from accumulating?

b. have you successfully or unsuccessfully negotiated with a card company? What worked or didn’t?

If you found this article helpful, subscribe to my free RSS feed, or sign up for free email updates! You may also find the following articles of interest:

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Free Google Docs and Excel Personal Budget Planner Spreadsheets!