Find Financial Freedom

I recently read an article on this subject on a well respected financial portal. I didn’t like the article that much because I found it a little one sided, and focussed solely on the notion that if you are in debt, it’s your responsibility to repay the debts.

Hang on a minute, the people you owe money to (the Banks) are the same w*nkers that have caused the global credit crisis at the moment by being irresponsible with their lending decisions in the pursuit of quick profits and seven figure bonuses, should we really extend anything but contempt to these people?

I propose that if you are in debt, you should seriously think about taking this opportunity to wipe the slate clean – remember, the banks have all been bailed out by the government to the tune of billions of tax payers money, your money, so why not let your own taxes bail you out too?

I know, I know some of you are probably thinking “how irresponsible and anarchic”. Well if so, look at your retirement fund, your ISA’s and the value of your property. The reason they are all significantly less than this time a year ago is because of the aforementioned bankers and the mess they made of the financial system. If you were coming up to retirement age and have just seen 25% or more of your pension value wiped off, are you glad that may now have to work beyond the age of 65 or that you will have 25% or less money to live off than you had hoped for?

Enough of my rant, I’m probably a little biased as I was working as a mortgage broker, doing ok until the credit crunch came along and wiped my business out, so I don’t have any sympathy for lenders given the stress that I went through, not withstanding that as well as losing my business, my marriage failed, largely due to the stress that I went through in losing my business. Hopefully that should give a bit of context to my rant.

So my top tips for getting out of debt quick are, in descending order of speed:

Bankruptcy

By declaring yourself bankrupt, and choosing how you do it, you could write off 100% of the money that you owe. Clearly there are significant implications for bankruptcy, namely the effect it will have on your ability to obtain credit now and in the near future.

However, the effects of bankruptcy will only last for a maximum of six years, after which, it will no longer appear on your credit file, so will not affect your ability to borrow money. You may be obliged to inform a creditor that you have been bankrupt, but as long as you can prove you are discharged and it doesn’t appear on your credit file it won’t affect your ability to get a mortgage, loan or credit card.

In fact, if the banks don’t learn the lessons of the credit crunch, you may well be able to borrow sooner than that, albeit at a higher rate of interest, to reflect the increased risk that you represent to a lender.

Individual Voluntary Arrangement (aka IVA)

The exact amount that you can write off by going through an IVA will vary, dependent on what your creditors are prepared to accept as an acceptable loss (remember you are writing off your debt, and that becomes a bad debt for the bank on their balance sheet, so it’s in their interest to write off as little as possible). Generally, you should be able to write off 50%, in some cases, as much as 70%.

The IVA process will take five years typically, whereby you agree to pay off what you can afford, in regular monthly payments over sixty months. There is an exception to this rule, the “One off IVA”, which is a one off, lump sum payment that is used instead of paying monthly for sixty months.

Again, as with bankruptcy, the IVA will severely affect your credit rating for up to six years after the end of the IVA, as I understand it.

Debt management plan

Is an informal agreement between yourself and your creditors that is very similar to an IVA. You agree to repay what you can afford, and your creditors agree to freeze or reduce interest payments and charges on your debts. As it is an informal agreement it does not affect your credit file, however, most lenders will only agree to a debt management plan on delinquent accounts, whereby there are arrears or even a default has been issued.

I would suggest if you are going to use a debt management plan, use it as a short term plan for one year, get yourself on your feet financially, then raise enough money to make an offer to your creditors to settle the remaining debt. I would start off by offering 25% of the remaining debt as a “full and final settlement” and increase the offer by 5% increments until all the creditors agree. This way, you will have saved yourself having to pay back 100% of the debt, and will not have had to pay interest for the previous year either.

Debt consolidation loan or remortgage

If you want to keep your credit rating in good shape, but need to clear your debts quicker, then one of the best things to do is look to reduce the amount of interest you pay. If you have various loans and credit cards, calculate how much you owe altogether, borrow that amount from on personal loan or remortgage and use it to repay all the other debts.

This system will only be of any benefit to you if you commit to using the money that you are saving by having all your debts in one loan to be overpaying the loan and thereby reducing the amount owed.

Focus on most expensive interest rate first

If for whatever reason, you don’t want to consolidate or simply can’t consolidate your debts, the next best thing to do is focus on repaying the most expensive card or loan first.

To do this, you will need to pay the minimum payments on all your other debts, work out how much all your repayments come to each month, and then work out how much you can afford to overpay on your most expensive debt and commit to making that payment until it is cleared.

Once you’ve cleared that debt, take the money you were using to pay off that debt and add it to the minimum payment on your next most expensive debt until that is cleared and repeat the process until all the debts are cleared.

Naturally, you will need a certain amount of discipline to do this, and you will also need to ensure you set yourself a budget to live off each month and stick to it. Another useful tip for those that are messy with their money, is to have two bank accounts. One is where your income is paid into, and the other is used to spend money. If you work out your monthly budget for all your outgoings, mortgage or rent, council tax, insurance, utilities, phone etc, you can leave the exact amount of money needed to cover these expenses in the first account, then transfer the remaining money into your spending account. This way you can never overspend and accidently spend money that was earmarked for something important, like the mortgage for instance!

Conclusion

I don’t recommend that anyone takes my thoughts on the subject of debt as advice, because it is not – it is merely my thoughts about the subject and some interesting ideas for those that are prepared to think a little differently…

I recently read an interesting article on Debt Avalanche? Correct?, this article was an examination of which method is best for repaying credit card debt. It examines two distinct methods; the debt avalance method and the debt showball method.

What I found from reading the article and both methods is that it doesn’t take into account interest, so I thought I would do a more in depth look at this situation using some real numbers, and also take into account the effect that minimum payments have on your strategy.

I’ve taken the numbers used on the BeatingBroke example, however I’ve slightly modified the minimum payment for one of the cards, as in his example the minimum payment was less than the monthly interest, which is not possible with a credit card – or if it is allowed in the states, then that does explain the credit crisis…

So we’ll start with Joe Bloggs, who is in my example a twenty something who’s started to take his finances seriously and decided to pay off his credit cards. He has decided that each month has an extra £300 that he could “overpay” his credit card balances. He has the following cards with the following balances, interest rates and minimum payment amounts.

Method 1 – Debt avalanche

This method states that you should arrange your debts in order of highest interest rate and repay the highest rate off first and descend through to the lowest rate.

Method 2 – Debt snowball

This method states that you should pay off the smallest balance first, so as to get a sense of achievement early on, then work your way up ascending through to the largest balance last.

I’m a bit of a numbers guy so I have used a spreadsheet to work out in our example which method is the best. I’ve assumed that for each card, the initial minimum payment is made regardless of what the minimum payment would be as specified by the card provider.

I have found that when interest is included, the debt avalanche method pays the cards off one month quicker than the debt snowball method. There really is not a great deal to choose between the two methods.

I wonder what would happen if the figures were different though. What would happen if the balances were significantly higher for a couple of the cards? What would happen if the minimum payments were different for each card?

There is also another method to use to repay the debt, which is simply putting all the cards onto their minimum payment each month, and using the excess that would have been spent on a fixed minimum payment to overpay the card that is being targeted.

What I will do, is using the figures from the initial example, build a model that tests both the snowball method and the avalanche method to see which model works best, when combined with my method, which I’m going to call the single focus method.

The results of my spreadsheet are that by using the single focus method, you will pay off the debts one month earlier using the new method, however, you do pay more interest during the course of paying the debts off. Not a huge amount of extra interest, in fairness. I suppose it’s a trade off between paying more interest or paying the debts off quicker.

In reality though, you would have to be very anal to actually set this up, and it would be much easier to simply use the debt avalanche method as that requires much less mathematical/spreadsheet ability. Only if the debts were significantly larger would it be worth using this more complicated method, as the savings in interest would become more significant with a larger amount of debt.

If your debts are at a point where you think they are somewhat out of control, there are a number of things that can be done to help alleviate the problem.

Firstly, don’t fool yourself into thinking that something magical will happen to relieve the stresses on your finances, as that’s denying the existence of a problem. Unless you choose to do something about spiralling debts, then they will simply continue to get out of hand.

Negotiate with creditors

The first step is to negotiate with your creditors. If you simply cannot afford to make the payments, then you need to communicate that to your creditors. If you can give a reason why things are difficult (drop in earnings, loss of job, illness/injury etc), show them what your income is each month, and show a reasonable amount for each of the necessary outgoings (utilities, food, petrol etc), then you should be able to get your creditors to agree to reduce the amount you are have to pay them each month to a figure that is affordable.

Full and final settlement

If things do not improve, then there are other ways that you can reduce the cost of your debts. If you have some capital, you can use that as a payment to pay off a portion of the debt, and negotiate with your creditors to “write off” the remainder. This is called “Full and final settlement”.

Individual Voluntary Arrangement

If you don’t have any capital to use as a full and final settlement, you could do an IVA (individual voluntary arrangement). This is a formal arrangement with your creditors over a period of five years, whereby each year they asses your in an effort to see if you could afford to pay more back. By freezing interest, the majority of the money being repaid is used to repay the capital (some of the money may be used to pay for the insolvency practitioner). By entering into an IVA, you will adversely affect your credit rating for up to six years from the end of the agreement.

Bankruptcy

If you are not eligible for any of the other options, then filing for bankruptcy is an option. When you are declared bankrupt, all of the debts are written off. If you have any assets, they can be seized to help reduce the amount being written off by the creditors. Once a bankrupt, you will have that on your credit record for six years, however, there are many lenders out there that will lend to discharged bankrupts. A discharged bankrupt is someone who was declared bankrupt over twelve months previously, although in some instances it is less than twelve months. Again, bankruptcy is a formal arrangement with your creditors and will realistically in the current financial climate adversely affect your credit rating for up to five years after you have been discharged.

Some useful resources include:

http://www.debtdr.co.uk/ - Debt Doctors independent debt advisors
http://www.cccs.co.uk/ - Consumer Credit Counselling Service
http://www.citizensadvice.org.uk/ - Citizens Advice Bureau
http://www.bba.org.uk/ – British Bankers Association debt help factsheet

I come across lots of people who are in debt, and they are usually looking for me to give them ideas on how to get out of debt.

So if you do have debt, how do you get out of debt? It’s not easy, for most people, the reason they have got into debt is because they have over-spent. This is usually because they have not properly budgeted each month.

How do you budget? You create yourself a spreadsheet, at the top you put in your after tax monthly income, then beneath it, you put in a description of every known monthly cost you have (mortgage, utilities, debts, food, petrol etc), with the amount next to it. At the bottom, you need a subtotal for all of your monthly expenditure. Lastly, you need to have a line called disposable income, which is remainder of the after tax income with the outgoings subtotal subtracted from it.

Once you have your monthly disposable income worked out, you need to work out how much that is each week, and then make sure that you don’t spend more than that each week. If you can be disciplined and live within the amount you have budgeted for, then you will be able to get yourself out of debt.

If you don’t have any disposable income, perhaps the debts and all your other monthly outgoings are greater than your income, you need to consider some fairly drastic action as a deficit each month will just exacerbate the problem.

I will post another article tomorrow on some solutions to debt problems that are spiralling out of control.

I work as a mortgage broker, and in my time I have come across many clients who, surprise, surprise are in debt. Many of them have a number of credit cards, with maybe a loan in the background and an overdraft. They are usually all living beyond their means, however in some cases it has been because they were studying to better themselves. I am usually asked if I can help by re-mortgaging to reduce the monthly outgoings, at the expense of increasing the time it takes to repay the debt. This is usually a good thing to do, as the money they save on interest, they can use some or all to repay the debts quicker.

In some instances, the client’s have let me know that they’d been doing these 0% balance transfer deals on their credit cards, as they thought it would help them to reduce their debts by paying less interest. What has usually happened is that they have cleared some of the debt a bit quicker, but actually found themselves more stretched because the monthly payments have been bigger. That’s odd, isn’t it?

What most people (and even the so-called experts) fail to check when shifting debt from one card to another is the minimum monthly repayment required for each card. This can vary from 1% to 3% or more of the remaining balance.

So you can see how a balance of £5,000 shifted from a card charging 15% annual interest and requiring 1% of the balance as the minimum monthly payment would only cost £50 per month compared to a 0% annual interest balance transfer card requiring 3% of the balance as a minimum monthly payment would cost £150 a month.

That’s quite a significant difference in outgoings each month, which is ok if the budgets aren’t stretched, but more often than not, they are. Make sure that you check what the minimum monthly repayment is each month before signing up to a new 0% balance transfer card, unless of course, you plan on paying back a lot more than the minimum each month.

In response to my post on types of debt Maria asks:

…which category would ‘buying a house’ fall into?

If you’re a devotee of Robert Kiyosaki (Rich Dad, Poor Dad) then you’ll know that he considers a house to be a liability and would therefore classify the mortgage as a "bad" debt. However I don’t think it’s that simple, after all you have to live somewhere and that somewhere is going to cost you money whether you own it or are renting it.

In my opinion mortgage debt is wasteful debt if you’re living in a house that exceeds your needs, i.e. a married couple using only one bedroom in a five bedroom house.

If on the other hand the mortgage is to purchase a home that meets your needs and it costs (in terms of the interest) roughly the same as or less than it would to rent a similar property then I would consider that to be an enabling debt as you would have had the negative cash flow anyway. But by owning your home you have a more stable family lifestyle, are able to add value to it and over the medium to long term it should rise in value giving you a return via the capital growth.

I do not however advocate buying your home in the hope of a capital return. Instead focus on it’s effect on your cash flow. Equally if you already own your own home I’m not keen on the "sell to rent" concept.

If you read just about any book, blog or article on personal finance or financial freedom you’ll come across the concept of debt being either ‘good’ or ‘bad’. I disagree with this philosophy - there is no such thing as a good debt as taking on debt involves taking on risk (and as a entrepreneur bad debt implies someone has failed to pay me, which I never let happen). Instead I prefer to think in terms of:

• Wasteful debt;
• Enabling debt.

So what do I mean by these terms?

Wasteful Debt

Wasteful debt is debt incurred buying products or services that:

• You do not need (or do not need such a premium version of);
• Result in a negative cash flow;
• Lose their value immediately/are impossible to resell.

A good example would be buying a top of the range executive car, you probably don’t need such an expensive car: a cheaper one would get you where you are going just as well, even if you never use it the car costs you money in tax and insurance and finally new cars lose a lot of their value as soon as you drive them off the forecourt - so if you sold it a week later you’d not be able to clear the debt.

Wasteful debts should be avoided as they waste your cash, reducing the cash flow you have available.

Enabling Debt

Enabling debt is debt that is incurred to enable you to create an income in excess of the cost of servicing the debt.

If the previously mentioned executive car costs £1,000 per month for the next three years but enables you to operate a executive taxi/chauffeur service that will turnover £4,000 and create a profit of £2,000 after costs (including any payments against the debt) then that debt has enabled you to create a positive cash flow of £2,000 per month.

In my opinion enabling debts are acceptable, wasteful debts should be avoided but no debt is ever good!