Client Situation
At age 37, Melissa has worked in the telecom industry for the past 15 years. She has two children and her husband Stephen is a self-employed wrought iron fabricator. Stephen's business is unpredictable for the most part but he always manages to get a least two small jobs each month.
Over the past seven years Melissa incurred several debts for various things, including helping Stephen acquire equipment.
Melissa's borrowing started with a credit card and, after several limit-increases, it is now maxed out at $19,500. She has two credit union loans: one is twice her shares at $80,000 and the other a recent unsecured vacation loan with a balance of $23,000.
Her monthly payments are $1,500 and $700 respectively plus $100 going towards shares. The credit union has always been her backup plan in event of emergencies and other minor expenses but the last time she borrowed money the loans officer suggested a cool off period for at least a year. Melissa also has three unsecured bank loans with balances of $7,000, $9,000 and $17,000 with payments of $775, $900 and $650 respectively.
Melissa has a debt service ratio of 43 per cent. After accounting for loan payments and basic living expenses, she often comes up short in the vicinity of $1,100, which Stephen manages to cover from his business after paying the rent.
The only savings that the couple has are two life insurance policies with combined cash values of $13,000. Melissa and Stephen are concerned that the situation will only get worse and the hope of purchasing a home is fading; much less moving from debt to wealth.
Nick's Assessment & Advice
Credit or rather debt is a tool and if used improperly any tool could be dangerous. A stable and well-paid job is most times the genesis of an addictive borrowing cycle. The problem usually arises when individuals get accustomed to borrowing for everything including things that neither create assets nor wealth.
Each debt added will encroach upon a person's ability to save causing them to be increasing reliant on borrowed funds. The cycle often stops–as in Melissa's case–when a creditor declines a facility or recommends a waiting period.
The sad thing is; individuals who are forced to wait often seek out more expensive and riskier loan options to deal with pressing needs. Further when the relevant waiting periods are over, they simply jump right back into the game whether they need the funds or not.
Melissa and Stephen's first financial objective is to get out and stay out of debt. Once they achieve this they will then be in a position to save for the things that are truly important. Each individual's debt portfolio is different and with these variations the strategy to eliminate debts would different.
Debt elimination approach
The first thing that the couple needs to do is to stop borrowing especially for non-essentials. The next step would be to stack up all the debts with balances; payments and collateral then run scenarios for debt restructure, consolidation, application of lump-sum payments from cash or other assets plus accelerated payments.
When each debt is repaid the payment that falls off should then be rolled into the next highest priority debt.
Whilst paying off the highest interest debt is often the recommendation because of the long-term financial impact, a person with a cash flow challenge should try to regain cash flow quickly and this may mean clearing the smallest debt with the largest payment as the ranking method.
There is a key relationship between the balance of a debt and the monthly payment that points to the best debt to attack first. The trick is to divide the monthly payment by the balance of the debt and solve it as a percentage (repay factor). The debt with the highest repay factor will be the highest priority debt to focus on.
A point to note is that anytime an extra monthly payment or lump sum is applied to a debt the lender must direct it to the principal (outstanding balance) and not as a prepayment held in suspense.
Additionally, when a fairly significant reduction is made to a debt, the balance could be rescheduled (not refinanced) for an even smaller payment to free up cash flow. The improvement in cash flow can be used to cover regular living expenses (eliminating the need for new debt and also allowing for some savings) or redirected to clear off debt using part or all of the savings.
The three bank loans have the highest factors and will have the most significant impact on cash flow if repaid or consolidated (See Table 2).
The consolidation did not include the credit card or the credit union loans. Whilst the credit card has the highest possible interest rate it is still more flexible thank the other debts as once she pays the minimums she can reuse the increased available funds for regular purchases. If this debt were to be consolidated she would lose the wiggle room it provides, as she will be obligated to make a non-refundable principal and interest payment.
The credit union debt was also not included in the consolidation as the repayment factor was very close to the estimated consolidation factor and may have a cost much lower than the bank's unsecured rate.
Debt acceleration
Melissa can consider using some or all of the savings from her cash flow to clear the other debts faster. She could make extra payments to the next priority debt: the credit union loan #1, as this is more likely to be repaid faster than the other remaining debts. She should then direct her efforts to the credit union loan #2. Once she gets the loan balance equal to the share balance she could use the shares to clear the debt and free up an additional $1,500.
Melissa may also have an option to utilise part of her insurance cash values to fast track the process. The only challenge with this is if there is an emergency they may have to go back to. At the end of the day once the couple is clear in their minds that being debt free is a worthwhile objective then any necessary debt incurred from here on will simply be included in the repayment strategy.
If you have any further questions or need advice on today's subject please email me at: NickAdvice@gmail.com or web me at: www.FinancialCoachingCentre.com