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Lesson 6: Wise Debt Reduction

Lesson 6: Wise Debt Reduction

Summary:

Wise Debt Reduction

  • Good personal finance principles always include an “Emergency Fund” (cash) that you can use in a time of crisis
  • Good personal finance principles and Wise Credit Management principles include paying down any revolving lines of credit as soon as possible (using cash to reduce debt)

How do you do both of these things at the same time?

  • Wise Debt Reduction: Pick a credit card that you can use again in an emergency and pay it down as soon as possible (turn cash into available credit)
  • Focus on giving up “this” so you can have “that” (give up something you are spending money on but don’t need) so you can have:
    • Lower debt
    • Higher credit scores
    • An emergency fund (emergency credit is almost as good as cash)
  • Be aware that some credit card companies will use a technique called “Chasing the Balance”, which means they lower your limit as you pay your balance down (if that happens, pay down a different credit card or get bad credit removed so they won’t continue doing that to you)

Wise Credit Management is a free Bible-based class that teaches how credit really works by showing factual information directly from the Credit Bureaus and FICO, and simplifies the subject to show everyone how to build good credit or handle bad credit. The class is fairly comprehensive and focused on getting good credit to qualify for a good mortgage rate and terms. WiseCreditManagement.com is a free community for members to take the class, join local groups (online or in person) for mutual support, and to find local professionals who volunteer to use their skills to assist members to success.

I am not a lawyer or Credit Repair Organization.

Home ownership is the way most Americans build wealth and a lack of education about credit is a huge contributor to the growing “Wealth Gap” in our country. Wise Credit Management is focused on teaching how to get good credit and qualify for a good mortgage rate and terms.

My work is protected by the “fair use” section of U.S. Copyright Act.

Proverbs 22:7  ~ The rich rule over the poor, and the borrower is slave to the lender. ~

Houses appreciate, cars depreciate, and credit cards create financial slaves.

To get on the right side of the “Wealth Gap” you need to be in the position to benefit from debt rather than being a slave to debt. From a practical point of view, most Americans only benefit from two types of debt: Student loans to develop profitable skills and earn higher income, and mortgage debt to own a home that appreciates over time. Automobiles can be an expensive burden that we learn to live with by telling ourselves that we “need” transportation. We will cover that subject in the “Graduation” lesson, but for now let’s focus on getting you out of consumer debt.

Many times, we owe money on credit cards because of bad spending habits or an unforeseen event. A medical situation or job loss can wreak havoc on someone’s personal finances and cause massive amounts of debt to pile up. Bad budgeting is also a major source of consumer debt. Buying a more expensive car just because it’s so much more appealing and only $100 per month more (for only 24 months more) than the one we thought we were going to buy. Or even eating out for family dinners, Christmas, birthdays, etc.

Then there’s emergency situations where you have to use all your available resources just to make it through. The Texas Blizzard of 2021 was a great example of an emergency that caused a lot of damage, cost a lot of money because of property damage, and for wage workers it cost several days of work, so they had a lower paycheck during a short month (February). Credit card debt happens to the best of us, but we need to handle it the best way possible and remember the difficult burden it caused and the hard work and sacrifice to get out of it, so we don’t get into that situation again. Hopefully going through this burden once will be enough to keep you out of debt in the future.

Most of us think about the future and retirement as some far-off thing that we will have plenty of time for later, but for right now we need to survive and find a way to make ends meet. The principle of compounding interest in a retirement account is great in theory but it isn’t relevant when you are struggling to make your car payment and credit card bills. Here’s the thing, compounding interest also works against you when you’re in debt. You’re the one giving someone else the interest on the money they invested to lend to you. Your current spending is funding someone else’s retirement account.

Think about yourself in the future when you get closer to retirement (your “future self”). How do you want to spend that time in your future? When you spend money today rather than saving it for your future, you are taking money from your “future self” and spending it on a car or a cool new cell phone today. It’s like borrowing from yourself while you are retired and trying to make ends meet today, instead of being able to enjoy having grandchildren and enjoying the time you have when you get older.

Learn From Mistakes

There is one positive change that can come from getting into a huge debt burden while you are young. You have the opportunity to change your spending habits and develop the mindset of saving to invest for yourself rather than spending to fund someone else’s retirement.

Let’s look at credit card debt. According to CreditKarma’s debt repayment calculator (creditkarma.com/calculation/debtrepayment) a $10,000 credit card balance at 20% interest will create a minimum payment of about $200 per month. It will take about 9 years to pay that off while also paying $11,680 interest. What if you took this year’s tax refund check of $3,000 and instead of buying something with it, you stopped funding someone else’s retirement and gave it to your future self by paying down that credit card. Now you only owe $7,000 which will only take 5.5 years to pay off at $200 per month. And that $3,000 tax return check will have saved you about $6,000 in interest.

How do you get out of debt? You have to choose to sacrifice your current lifestyle, or what I would say is you have to give up “this” for “that”. Look at what you have that isn’t necessary for survival. Do you “need” cable or to go out to eat? When you go grocery shopping, do you need desserts like ice cream and cookies? When you go clothes shopping, do you really need that brand? Most people can cut $100 per month out of their budget, it’s just that they don’t want to give up this thing right now to get that in the future. It helps if you see it as if you are giving that to your future self.

Develop (And Use) A Plan To Reduce Your Debt

There are several approaches that are common and have good results. Choose the one that you believe works for you and stick to it. Dedication is the most important thing and a lack of it can derail the best laid plans. People get side tracked or derailed entirely because they don’t follow their plan. As I mentioned before, the good thing about being burdened with debt is that experience teaches you that you can do without the things that you don’t “need” to survive.

The Debt Snowball is the most well-known and a very effective plan to reduce your debt. The premise is that you use any extra amount in your budget ($100 per month from the above example) to pay extra toward your LOWEST BALANCE debt. You will eventually pay that debt off and be able to enjoy the accomplishment of having a $0 balance on one account, which should give you the psychological reinforcement to keep going on to the next account. You then take the $100 per month and add the minimum payment you were making to that account (maybe $20 per month) and continue to pay off the next lowest balance debt. Now you are paying $120 per month extra toward your next lowest balance debt which is the “Snowball” effect of adding a little more as it rolls down the hill to having all your debt paid off.

The Debt Avalanche is a slightly less well-known but very practical approach to reducing your debt. The premise is that you use any extra amount in your budget ($100 per month from the above example) to pay extra toward your HIGHEST INTEREST RATE debt. You will eventually pay that debt off and be able to enjoy the accomplishment of having a $0 balance on one account, which should give you the psychological reinforcement to keep going on to the next account. You then take the $100 per month and add the minimum payment you were making to that account (maybe $20 per month) and continue to pay off the next highest interest rate debt. Now you are paying $120 per month extra toward your next highest interest rate debt which is the “Avalanche” effect of reducing the interest you pay on your debts until all your debt is paid off.

You may have noticed that I used very similar wording to describe both methods, the main difference is that in the “Snowball” you pay off the lowest balance first and in the “Avalanche” you pay off the highest interest rate debt first. They are very similar and will get you out of debt at practically the same time. According to the Harvard Business Review (hbr.org/2016/12/research-the-best-strategy-for-paying-off-credit-card-debt) more people stick to the Debt Snowball approach and therefore it will help the most people even though the Debt Avalanche will pay off consumer debt faster and reduce the amount of interest paid. The Debt Snowball gives people a sense of progress through “Small Wins”, and they are more likely to keep going.

We know that credit cards are the “Emergency Fund” for most people. As you can see from the above example involving using an Income Tax Refund, I am basically advocating for using most extra cash you have to pay down debt. But what if something happens and you put all your money toward paying off a credit card that you cannot get back In Case of Emergency (ICE). If you have a large amount of money in a bank account and a large amount of debt at 20% interest, you are losing 20% per year on your cash, which will not get you to your goal of homeownership because your credit scores will be lower and your Debt To Income Ratio (DTI) will be higher. So how do you manage the need to have an emergency fund, the need to have a higher credit score and lower DTI, and the need to pay down debt?

Wise Debt Reduction

The Wise Credit Management approach is called Wise Debt Reduction. When you want to own a home you need to balance the need for a higher credit score (through lowering your Utilization Ratio… Lessons 3 through 5) with your need to lower your DTI (you minimum monthly debt payments) with your need for an emergency fund (you will need some money in your bank account for a Down Payment, Closing Costs, and Reserves when you close). I advocate for choosing which account you focus on to pay off first with the very practical consideration of possibly needing that money back later. Paying down a Kohl’s card (or any type of store card) first will give you a Snowball and/or Avalanche type of “Small Win”, but it will not be there for you if you need money to make an emergency repair to your car so you can get to work in the morning. Therefore, in Wise Debt Reduction, the principle is that you first pay down the lowest balance or highest interest rate credit card that you can use to spend on the mechanic (or other emergency expense), In Case of Emergency (ICE). That way, from a practical “Real World” point of view you still have that money in an emergency fund, and it is saving you 20% interest on that card. It will also lower your Debt Utilization Ratio and it should lower your minimum monthly payment on that card which will reduce your Debt To Income (DTI) Ratio. In this way you combine the Snowball or Avalanche method (whichever is best for you) with the need for an emergency fund. If you are monitoring your credit score (see Lessons 3 & 4), Wise Debt Reduction will give you “Small Wins” by seeing your credit score increase slightly every month and combine that psychological benefit with lower balances and paid off accounts.

Please allow me to simplify everything I just said about Wise Debt Reduction; pick a credit card that you can use in a possible future emergency situation and concentrate on paying it down first so you can maintain your emergency fund while paying down debt AND increasing your credit score by lowering your Utilization Ratio.

Should you pay down term-loans before you buy a home? Pay down credit card (revolving) debt first. If you pay off a term-loan, the positive credit history you built on the loan will disappear very quickly and your credit score will actually fall (yes, I think that’s a fault in the scoring algorithm but I’m telling it how it is and not how it should be). However, when you pay down a revolving account and leave that account open, you reduce your Debt Utilization Ratio and your Debt To Income (DTI) Ratio while keeping the positive history on the account thereby improving your credit score. The only way to reduce your DTI by paying down a term loan is to pay the loan off entirely, reducing your credit score, or to be in the final 10 months of the loan, in which case the loan payments might not count against your DTI. DO NOT simply pay down the balance of the term loan to less than 10 months of payments, that won’t work to reduce your DTI. However, it might slightly improve your Debt Utilization Ratio on that account which will improve your score. Remember that (as we saw in Lessons 3 & 4) a term loan automatically increases your credit score over time by increasing your age of accounts and gradually decreasing your Debt Utilization Ratio. Pay credit cards off before term loans.

Balance Chasing

Can a credit card issuer reduce your limit while you are paying your balance down? YES! Credit card companies can reduce your credit limit as you pay down the balance of your account with them. This concept is known as balance chasing. If a credit card issuer sees that you keep using ONLY their credit card and then pay it off over a few months, the issuer will likely increase your credit limit. However, if the issuer sees you as an increased risk of default (usually measured by a decrease in credit worthiness), they can and will decrease your credit limit. That works against you in two ways. First, your debt utilization ratio stays the same and therefore paying the balance down does not increase your credit score and second, you will not benefit from the ability to use that card for an emergency fund. 

Many different factors can play into this situation. If a card issuer is monitoring your credit and sees that your cards are all maxed out, your issuers will likely see you as an increased risk of default. If your card issuer sees collection accounts, they will likely see you as an increased risk and reduce your credit limit. An issuer may reduce your credit limit for reasons that have nothing to do with your personal credit, don’t take it personally. Just make a choice to pay down a different credit card account.

If all the credit cards that can be used as your emergency fund begin “chasing” your balance, you will be forced to choose between keeping money in your bank account as an ICE fund and paying down cards like Kohl’s or a Gas card. When you pay those cards down to $0, your score will likely improve, and issuers might see you as less risky. If you have collection accounts outstanding you should strongly consider paying those off and then disputing them (as we will discuss in Lesson 7), then go back to paying off your credit card balances. It is worth noting that your score will likely be dramatically affected by any collection account, and it will likely benefit your score more to pay off that collection account (then get it deleted) with the cash you currently have in order to reduce debt.

Collection Accounts

Should you pay off a Collection or Charge Off account before paying down other debt? As we saw in Lessons 4 and 5, one late payment can drop your score 65 points. However, in Lesson 7 we will see that one collection account can drop your score by 100 points or more. To qualify for and close on a mortgage loan, you may need to pay off collections anyway. So, if you have collection accounts outstanding, the best thing to do may be to pay off your collection accounts to prevent Balance Chasing from credit card issuers. However, let me caution you that paying off a collection account will not affect your Mortgage Middle Score much, if at all.

We will discuss this situation in much more detail in Lesson 7, but for now just know that a collection account on your credit report will likely hurt your score by 100 points or more and only paying it off won’t bring many points back. You can, however, do a “Pay For Delete” arrangement (this is a negotiation strategy where you agree to pay off a collection account in exchange for the creditor removing it from your credit report). Be aware that not all creditors will agree to this arrangement because it violates the Metro-2 system. You could simply pay the collection off and then dispute the collection account afterwords to get it removed from your credit report.

Commitment

“We cannot solve our problems with the same thinking we used when we created them.”

– Albert Einstein                               

You likely have to make major changes to your lifestyle to achieve the desired goal of getting out of debt and owning a home. Turn your cable off, stop buying cookies and ice cream, do not eat out, etc. It’s a lot to ask for one person to make those changes. But now you must be drastic in how you get out of debt.

Wise Debt Reduction requires a commitment from the person (or persons) who owes the debt and it requires a mutual commitment from anyone who will benefit from better scores. If you are in a relationship, both of you need to be committed to your debt reduction plan. If you don’t have a mutual commitment, the person with less commitment will likely break the commitment in small ways which will cause conflict. However, mutual commitment will create mutual accountability. Both people in the relationship need each other to be committed and accountable for the end goal AND the steps of the process.

Your Plan

Using Specific, Measurable, Achievable, Realistic and Time bound (SMART) goals, you need to break your debt reduction plan into specific steps. Use the principals we just discussed in Wise Debt Reduction to decide which debt to start with and do whatever is necessary to accomplish that first goal. Then look at your results. Did your score increase (even slightly)? Did your overall balances decrease? Did you pay off your first debt? Take a deep breath and enjoy a small win.

Consider these as SMART goals:

Specific:               Pay down $500 on my highest interest rate credit card in the next 4 months

Measurable:      The balance on your credit card statement needs to be $500 lower at a certain date

Achievable:         I can do this by making a choice not to go out to eat every other weekend

Realistic:              This will take discipline, but saving $125 per month by not going out is possible

Time Bound:       4 months is a good time period to focus on

Use your system of credit monitoring to track your progress. You will feel a sense of accomplishment every time your credit score increases.

Remember, WE CELEBRATE SUCCESS! Small wins keep you going in the right direction. Every step you take in the plan to get out of debt will help build momentum and the positive attitude necessary to follow the plan for however long it takes. Treat yourself to a non-financial reward. If nothing else, pat yourself on the back!

You have to decide if your desire to own a home is more important than your cable bill. Decide if increasing your credit score feels better than buying ice cream. Decide if you would rather go out to eat or increase your emergency fund and pay down a credit card.

As Your Score Increases

If your score is low and your cards are maxed out when you start, your score will go up as you pay down the balances on your accounts. If your score gets to a higher level, maybe from 630 to over 670 (or 720, or 760), you could always call your credit card issuer and ask for a lower interest rate or a credit line increase (CLI). A lower interest rate will slightly decrease the interest you pay, and a higher credit line will decrease your utilization Ratio which will increase your credit score.

You can also try to refinance an auto loan or try to get a balance transfer term loan. Remember what we covered in Lessons 3 – 5, that a new credit account or even a “hard inquiry” will reduce your credit score for a few months before it improves your credit score. However, if your timeframe is over 6 months and you can improve your financial position by refinancing something you probably should.

Galatians 6:9  ~ Let us not grow weary while doing good, for in due season we shall reap if we do not lose heart. ~

How long did it take to get into the situation you are in now?

Does it stand to reason that it might take you the same time to get out of that situation?

Make a “Wise” Debt Reduction plan, stick to it and do not loose heart. Good things take time.

Next: Complete the Lesson 6 Quiz (first make sure you completed the Lesson 5 Quiz)