What Educators Won’t Tell You About Managing Personal Debt
Why take 15 years to pay off a personal debt amounting to $2,162 that will cost almost $4,000 in interest, calculated at 18.84 percent per month? Who would do such a foolish, thing? The answer is a simple one: neighbors, friends and relatives — millions of people — who have a lack of understanding of how to properly manage their personal debts. This long, long list of fiscal self-abusers could even include you. Welcome to the club.
Degrees don’t protect you. I have two degrees from two highly respected institutions (Johns Hopkins University and the University of Chicago), yet I can state categorically that the business courses I took did not prepare me to handle my personal finances. In short, the system does not provide the education needed to manage debt.
Also to blame are the lenders for not providing the information needed to make intelligent financial decisions. Insurance companies and bankers don’t want us to be too smart — they would lose money. The solution, of course, is to get out of debt and stay out of debt.
I tell my students that four basic rules must be understood and applied in order to get out of — and stay out of – debt:
(2) education and information
(3) a plan
(4) the tools to generate information and a plan.
Without the desire to become debt-free, nothing will happen. You have to want to. The “want to” could be driven by the fact that each month you spend $800 to $2000 to retire debt. Money that could be used to fund a retirement plan, educate the children, create an emergency fund or improve your lifestyle.
Add a Dollar
Education about debt begins with an understanding of how interest is calculated. It won’t take long to conclude that the higher the balance, the greater the “rent” or interest for the period. Education continues with understanding the devastating impact late charges can have on an account and the realization that late charges should be avoided at all costs. It’s also, important to understand that it’s never too late to pay a late charge; simply include it with the next payment. Add an extra dollar to eliminate the compounding at the interest.
Two other concepts are needed to round off your education — an understanding of “minimum payments” and the impact of “extra dollars” on an account. Consider my opening example: balance, $2,162; monthly payment, $36.00; interest rate, 18.84 percent This is all the information we normally have for our accounts, but unfortunately, it doesn’t tell us much. The missing piece of information is the number of remaining payments. Would you believe that it will take more than 15 years to retire this account and that the true amount the lender will be paid is $6,615? That’s almost $4,000 in interest.
In other words, if you couldn’t afford $2,162.00, you certainly can’t afford $6,615.00. If we were to analysis for each of our accounts, we would determine that our true debt is not the sum of our balances but the sum of our balances plus the projected interest charges. Our true debt is 20 to 60 percent greater than our current balances. Being in debt is expensive.
The good news: increase the payment by just $1 ($37, instead of the $36 minimum payment) and you will reduce the number of remaining payments by two years and save almost $700 in interest. That means that your money is working at a guaranteed rate of more 20 percent. What a difference a dollar can make!
The Triage Method
The most common instrument for getting out of debt is loan consolidation. Unfortunately, in most cases, this practice puts us deeper in debt because it lowers our monthly outlay. To counter this, I have developed a methodology for getting out of debt that I call the Triage Method.
It’s similar to consolidation, in that your monthly outlay is fixed until all bills are paid. In other words, if you are currently paying $1,000 a month, you would maintain that amount until all bills are paid in full. Your accounts are ordered by the number of remaining payments, lowest to the highest. As a bill is paid in full, its payment amount is applied to the next bill. This continues until all bills are paid in full.
This has the same impact as adding extra dollars onto your bills. The screams that you hear, this time, will be from your lenders. Following a plan that uses this formula will guarantee that you will get out of debt sooner and save hundreds or even thousands — of dollars in interest. It’s like magic.
A final word about staying out of debt — I encourage my students to develop an emergency fund. it should have six months of expenses in it. If your monthly expenses are $3,000, your goal for your emergency fund should be $18,000 — and it should be the best-kept secret in town.
When you need to borrow, borrow from yourself. Of course, do not forget to repay yourself. Never buy an automobile that you cannot pay cash for. If you cannot afford it at $20,000, you probably cannot afford it at $24,000. Accumulate money for your next car in your emergency fund. if your goal is to purchase a $25,000 automobile, I guarantee you that when the time comes to pay cash for that car, you will decide that all you really need is transportation — and you will settle for something less expensive. Life is funny like that.
Professor Bill Keating teaches a variety of personal finance courses at Montgomery College, Rockville, MD. Keating received his bachelor’s degree from Johns Hopkins University and a master’s degree from the University of Chicago.
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