Financial Advisor, Insight Investment & Retirement Strategies
The main problem and two solutions
Joe & Lillian’s core problem is that their net income is only $5,333 per month but their combined debt expenses (based on current interest rates and probable repayment schedules) are now $2,860, 53% of the net income per month.
This is comprised of the following:
- Credit card debt minimum repayment of $600 per month ($333 interest at 20% p.a.)
- Personal loan (typically over five years) now in year four with $775 in repayments per month ($275 interest at 11%)
- Mortgage of $1485 month (including interest of 6.5% $850 per month)
This only leaves them $570 per week to live on. There are a couple of options.
Option 1: Debt consolidation into your mortgage
The simplest solution is to approach their bank and consolidate their credit card and personal loan into the mortgage, using the equity in their home, but maintain a high repayment schedule. Their new debt will be $207,000 and on the old remaining 13-year time frame the repayments will be $1,957, up from $1,485 per month.
But the total interest payments are now spread over another 13 years which is greater than the original car and car loans interest payments were over only five. So they still need to set a target of say 40-45% of income to service the debt.
At 45% of net income, the repayments should be $2,400 per month and the whole debt now will be eliminated in only nine years and nine months instead of 13 years. They will now also have an extra $100 per week to live on. If they occasionally wander off the repayments they have set themselves, then they will still reduce their total interest payments from $100,000 over 13 years to say $73,000 - $75,000 over the period they do pay back the loans.
This amount is close to the total interest that the home loan itself was going to be over the 13-year period. They have effectively eliminated the $50,000 in debt virtually interest-free, so to speak.
Option 2: The 18-month kill zone
An additional little twist to add value – if they really wish to kill their debt and can manage the existing repayments for just another 18 months is as follows:
1. Apply for another credit card that has a special 0% interest-free period to rollover the existing $20,000 card debt and repay that at the same rate as the minimum $600 per month required. All of this will go to reduce the debt, not half of it.
2. Consolidate the car loan debt with the mortgage but maintain the same repayment rate added to the existing home repayment. Then with your credit card the new arrangement will, over six months, eliminate $3,600 of debt and if repeated on another credit card, six months later will reduce another $3,600. At the end of a third six-month period they will have eliminated $10,800. There is a limit as to how long you can keep doing this and you need to get rid of the old cards as you acquire a new one with an interest-free period.
If they then add the remaining $9,200 to their mortgage in 18 months, the total amount outstanding will then be approx. $174,000 at that point in time. Then set the overall repayments at the 45% of income ($2400) the total debt will be eliminated in the remaining eight years and the remaining interest paid will be approximately only $48,000 (at 6.5%). However, great discipline is required to achieve this.
*Important: This is general advice only on credit card and debt management