Episode 254: February 14, 2012
Debt Loans Credit
by Laura Adams
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If you’re like most people, you want to ditch your debt as quickly as possible without having to take a second or third job. Having too much debt can be a real burden that holds you back from improving your financial life.
How to Get Out of Debt Faster
When it comes to getting out of debt, there are 3 basic strategies:
Don’t increase it
Reduce the interest rate
Reduce the principal balance
In this post, I’ll cover specific tactics to reduce the interest rate on your debt. And next time, you’ll learn how to reduce your principal balances.
How to Reduce the Interest Rate on Debt
The interest rate is the cost of borrowing money. It’s the amount you’re charged in addition to the principal amount you borrow and it depends on several factors including:
the current market interest rates
the length of the loan
the amount you borrow
the type of credit account
How a Lower Interest Rate Saves Money
Say you get a car loan for $20,000 with a 15% interest rate over a 5-year term. Your monthly payment would be about $475. If you got that same loan at 6% interest, your payment would be about $385, saving you $90 a month, or more than $5,000 over the life of the loan.
Think about what you could do with that money! If you invested $90 a month for 5 years and never added another penny to the account, you’d have over $30,000 in 20 years, assuming an 8% average annual rate of return.
What is a Loan Refinance?
So how do you reduce the interest rate on a loan that you already have? Well, one way is to refinance it.
Refinancing allows you to replace a debt with another debt. You get a brand new loan with a more favorable interest rate and pay off the old loan at the same time. The new loan could come from your existing lender or from a different one.
Loans that are commonly refinanced are mortgages and auto loans. You can pay less if interest rates are lower now than when you originally took out the loan. Additionally, if your credit score is better now, that could also make you eligible for a much lower rate.
However, getting a lower interest rate may not save money if your refinance also stretches out the term of the loan. For instance, if you have 20 years remaining on a 30-year mortgage and you refinance it back to 30 years.
Increasing the length of a loan will decrease your monthly payments, but it typically costs you more interest over the life of the loan. Plus, a longer term doesn’t help you pay off the balance any faster, which is what I’m focusing on here.
Therefore, to save the most money and pay your debt off as quickly as possible, refinance it for a lower interest rate using the existing payoff schedule, or a shorter one.
There are fees involved in doing a refinance as well as equity requirements for home loans, so speak to your current lender and shop around to find the best deal.
There are many online calculators at sites like mortgagecalculator.org, dinkytown.com, and bankrate.com to help you crunch the numbers and take a closer look at whether refinancing makes sense for your situation.
But what if you can’t refinance a mortgage because you’re underwater and owe more than your home is worth? A loan modification might be the solution.
What is a Loan Modification?
Getting a lower interest rate may not save money if your refinance also stretches out the term of the loan.
A loan modification is typically an option when you demonstrate that you have a long-term hardship or inability to repay a mortgage. It’s similar to a refinance, but with no fees.
A loan modification may reduce your interest rate, extend the length of the loan, or change the type of loan (from an interest-only to a fixed-rate product, for instance), or a combination of these solutions. In general, a lender would rather keep you as a paying customer with a modified loan than to foreclose on a property if you default.
Starting in May 2012, the federal government is rolling out a new and improved Home Affordable Modification Program (HAMP) to help more people. If you’re employed but struggling to pay your mortgage, this program can reduce your monthly payment to 31% of your gross or pre-tax income—even if you’re underwater.
Lenders will have all the details about the expanded program in February 2012, so be sure to contact them to discuss your options. You can also visit makinghomeaffordable.gov for more information.
What is a Loan Consolidation?
What if you have multiple debts—like student loans or credit cards—that are weighing you down?
Refinancing multiple debts into one is called a loan consolidation. Not only can consolidation save you money when the interest rate is reduced, but it makes managing the debt easier because you only have one payment each month.
Private and federal student loans can’t be combined, so they must be consolidated separately. Also note that any special repayment options included in your original student loan may be canceled if you consolidate it.
To learn more about your options for federal student loans visit loanconsolidation.ed.gov. If you have private student loans, contact your lenders for refinancing and consolidation options.
If you have debt on several high-interest credit cards, save money by consolidating them with a low-interest personal loan that you take out from an online lender or a local credit union. Any time you can substitute high-interest debt for lower-interest debt, you’ll save money that can be used to pay down the principal debt balance faster.
What is a Balance Transfer?
Another way to slash the amount of interest you pay on debt is to move it to a balance transfer credit card. This is a special type of credit card that offers low or no interest during a promotional period if you transfer existing credit card debt or a qualifying loan balance to the new card.
Just like with any credit card, your credit score will determine the credit limit and interest rate that you’re offered. Balance transfer terms and fees vary widely, so be sure read the fine print to use them wisely. Check out Should You Use a Balance Transfer Credit Card? to learn more.
If you’re ready for a brighter financial future, get 3 top strategies to raise your credit score fast in my free Credit Score Survival Kit. You’ll also find out how to get your credit score for free—so you can see when your score goes up or down, as often as you want without having to pay for it.
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To learn much more about dealing with debt in easy-to-understand language, get a copy of my book Money Girl’s Smart Moves to Grow Rich. It tells you what you need to know about money without bogging you down with what you don’t. It’s available at your favorite book store in print or as an e-book for your Kindle, Nook, iPad, PC, Mac, or smart phone. You can even download 2 free book chapters at SmartMovesToGrowRich.com!
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