Using Payment Strategies

When you are looking at ways to reduce your debts quickly and minimize your total interest charges, you may decide to pay your debts off at a faster rate, even though this will temporarily reduce your annual savings. In that case, it is important to look at any prepayment penalties that may be incurred if you pay off some of the balances you listed in your most recent debt load document (you can use the search function above for the areas are our web site that cover the tasks involved in creating your personal debt load document). All mortgages generally do not have prepayment penalties, but many consumer loans do.

Check the language of your loan and credit card agreements carefully for something called the “Rule of 78s,” which refers to the mathematical formula used. Unfortunately, if you see this term, it means that there are prepayment penalties. What happens is that most of the interest gets paid in the early months of the loan and less in the later months. On a one-year loan, this means that by the fourth months of the loan you will have paid over half the interest for the year. In contrast, a loan with interest computed on the “actuarial method” charges interest based on the loan balance as it declines, so interest is not loaded up in the early months and you avoid being penalized for paying it off early. I am embarrassed to admit that before I knew what to do or watch for, I ended up with more than one “Rule of 78s,” loan.

The Minimum Payment Mistake

With some credit cards it can take as long as 10 years to pay off a balance under the minimum payment provisions, where the required monthly payment declines as you reduce the loan balance. For example, let us assume you have a credit card with a balance of $5,000 at an interest rate of 18%. If your current minimum monthly payment is $40, even if you don’t charge anything else on your card, it could take you up to 10 years to pay off the $5,000 balance depending on how the interest rate is charged and how the monthly minimum payment due is determined. When I explained this to one of my clients in Hollywood
California, she immediately canceled her vacation plans and use the money to get rid of her credit card debt.

If you are short of cash one month, you may be tempted to skip a payment altogether and make up for it in next month’s payment. Don’t. Your failure to pay may be recorded on your credit report and thus jeopardize your credit worthiness. In fact, late payments are the primary cause of negative information on your credit report.

Fast Debt Reduction Considerations

Once you have completely filled out your current debt load document, you can assess whether there are ways to use savings on hand to pay down your loan balances, or increase the amount of principal that is being paid off each month and thereby reduce your interest. Furthermore, you could also make more of your interest tax-deductible. In any event, try to never get cost in the so-called minimum payment trap that, like the Energizer Bunny, keeps your loan going and going and going.