What is the Best Way to Manage My Debt?
BY DI IORIO & DI IORIO ACCOUNTING FIRM
As a general rule, you should always strive to have as little debt as possible. The reason is that interest expense is a cost that adds no value to what you own. It is only a usage fee that you pay to use someone else’s money. It can be compared closely with a penalty that is paid to a government much like a parking ticket. You really get nothing for it other than the opportunity to use someone else’s money.
Having no debt, or reducing it as much as possible will save you interest charges and other charges that are associated with someone else owning or having liens on your property; such as insuring and preserving assets to the satisfaction of lenders instead of having the absolute freedom to do whatever you want to do minimally as the sole owner.
A great example of this was when my associate asked me: “Should I pay off my car loan now with this extra $5000 that I have?” My answer was yes, because the interest rate of the car loan (5%) is higher than the risk-free rate of return on an investment such as a savings account (0.5%). The difference between 5% and 0.5% is a net interest cost of 4.5%. Your annual guaranteed savings will be 4.5% times $5000 equals $225. Plus- there is a bonus. When you pay off the loan, you can remove the lender entirely from your auto insurance policy and raise your collision & comprehensive insurance deductibles – this will save you extra money. (In the case of auto leases there are even more additional costs such as excess mileage fees and the cost of mandatory repairs for every little dent and scratch when the car is returned.)
In the case of credit card debt; including store credit cards; you should do everything possible to avoid it because of the egregious interest cost that it carries. Many credit cards charge 26.99% interest. If you have a $1500 balance, your annual interest cost will be over $400. Often these credit cards entice you to carry the balance by requiring small minimum payments that represent interest only. Imagine if you have credit card debt of $20,000? You annual interest cost would be over $5000!
Mortgage debt is usually a mandatory debt that most people have to incur because real estate is expensive and usually beyond the regular means of a home buyer. There are two golden rules:
- Make sure that your debt maturities match as closely as possible with the economic lives of the assets to which the debt was incurred; and,
- Make sure that you have obtained the lowest possible interest rate. Sometimes the achievement of number 2 will require you to take a fresher look at number 1. Specifically, in today’s low interest rate environment, an adjustable rate short-term mortgage loan will run at a substantially lower cost than a 30-year conventional mortgage. Therefore, when you see that a 3 to 5 year time horizon will have an interest cost of 1.5% as opposed to a 30-year lock rate at 3.95%, given a large sum of debt of say $250,000 (5-years of college education for instance), your savings by choosing the short rate of 1.5% would be about $6,000 per year; over 5 years it could add up to $30,000. So being creative with term in order to get the best possible rate is a smart approach. The key is to use your imagination to determine whether or not your time horizon can be shortened to justify taking this kind of opportunity.
Student loans follow the general rule stated above at the beginning of this article: avoid it. These loans are deceptive in that even the best “Federal Stafford Subsidized” student loans charge interest at rates that are much higher than the risk-free rate. Presently, this best rate is 4.29%. Beware that most student loan monies are not “Federal Stafford Subsidized”. Many of these other student loans are not recommended by Veritas Financial is there are good alternatives to having them.
Student loans are typically granted to borrowers as a package that looks like “financial aid”, but deep down, they are not “aid” at all. They are instead just like explained above, an opportunity to use someone else’s money at an above-market and sometimes usurious cost. The “financial aid” moniker is quite deceptive. Truly student loans need to be better governed by consumer protection laws and made more transparent to the student consumers. Watch out for student loans that charge you interest at high rates even while you are still attending classes!!! This area has become a predatory one where lenders directly; and universities indirectly are profiting from unaware consumers. We have observed that student loan debt information that is provided to borrowers is deficient and lacks important information (such as detail history with dates of accrual, and dates of advances) that a borrower needs.
Student loans have received some congressional support mainly for the sake of the universities and lenders – unfortunately NOT for the borrowers/ students. Tread carefully in this area. What looks like an obvious choice to freely spend on education is another mine-field for smart consumers.
This short report is an informational service provided to you by Di Iorio & Di Iorio Accounting Firm, located at 567 Park Avenue, Suite # 203, Scotch Plains, New Jersey. Visit us at www.diioriocpa.com
Our professional debt and finance experts have the experience and tools to help you to structure and implement a debt reduction plan and the best of debt management plans.
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