Rethinking strategies for managing debt in the age of coronavirus

01.04.20 08:25 AM Comment(s)

From the Clipboard-Debt-Rethinking strategies for getting out of debt

One topic that I’ve been asked by many people is on managing debt - credit cards, student loans, etc. In the current situation, how should strategies for managing debt change?


Obviously, if you’ve lost your job if you were the sole income source, or had your income substantially reduced, then call your creditors right away! Many lenders are working closely with borrowers with programs, accommodations, etc. to help people get through this.


If, however, you still have your job/income and are otherwise able to make your loan payments, then I believe that there is a strategy.


First and foremost, let’s review what we know - Federal student loans are now at 0% interest and no payments are required until Sept. 30th. This includes the Direct loans, Stafford loans as well as Perkins and PLUS loans. Not included are the FFEL loans that were granted years ago. Nor are private student loans.


What is not clear is whether or not loans directly from colleges have adjusted terms temporarily. For example, Northwestern, Tufts and Worcester Polytech are among the schools that offer loans out of their own money in addition to any Federal loans.


Now that we have that out of the way…there are 2 guiding principles:


1. Cash (and equivalents) is king!

Having a buffer of easily accessible and not-at-risk assets is important. Some people call this an emergency fund, but it can go beyond that. And I’m not just talking about money in a bank.


2. Cash flow is queen! Is that even a term?

The point is that managing your income and expenses, especially required monthly payments on debt is another priority.


Some strategies that you may want to consider:


Utilizing the student loan mortatorium to your advantage


The rationale is obvious here. Even if you have the money to pay the student loans, you can redirect, temporarily, the monthly payment towards building up a cash reserve and/or paying down other debt.


Smallest balance first, not highest rate


Many people think paying of the highest interest rate debt first is best. And yes, it could save you a lot of interest charges. But that’s not really important right now - cash flow is. So paying off your smallest balances first will free up those monthly payments in case your income is impacted in the future.


Credit cards first, even if rate is lower


Why? In an emergency, you can always borrow back up. Not ideal, but this can make up for a lack of an emergency fund temporarily. Imagine if you sent in an extra $100 payment on a car loan and then you needed that money back for something else. Can you get it back? NO!


But if you sent in an extra $100 payment on a credit card and needed it, you can borrow it again.


Refinance - Part 1


Many people are refinancing their mortgages now for a lower interest rate, but the real figure to be considered is the monthly payment. Here’s an example:


The payment on a $250k mortgage, 4% for 30 years is $1183/mo.

Same mortgage, but 15 years is $1840/mo.

For a difference of $657/mo.


If you pay the extra $657/mo on top of the 30 year payment, you still pay off the mortgage in 15 years. The difference, however, is that if you don’t have to extra money one month, or if you lost your job, you would only need to cover the smaller payment figure. Having that lower payment gives you flexibility and breathing room should something bad happen.


Refinance - Part 2


While refinancing a mortgage or getting a home equity line of credit is common for people, using their existing cash balances as the collateral is not. Instead of borrowing against your house, you can borrow against your own cash in the bank.


Many banks offer savings or certificate of deposit secured loans. And since the cash in the bank is the collateral, the rates tend to be lower since the risk is lower for the bank.


I worked with a client recently on this situation:

$10,000 cash in the bank

$7,000 loan against the cash to pay off a high interest rate credit card

1% earned on the savings account

4% loan rate

5 year loan


Normally, people would take the cash to pay off the credit card. But you may want to consider this other option. If you borrow the $7,000 against the cash for 5 years at 4% (3% over the savings rate), the total interest paid is $735.


The $10,000 entire amount keeps earning interest at 1%. For 20 years (until retirement for this client), the account would earn $2,200. Subtract the $735 in loan interest paid, the net interest earnings is $1,465.


On the other hand, had you used $7,000 to pay off the credit card, you would not have paid any loan interest. The remaining $3,000 at 1% for 20 years, total interest earned is $660.


Which would you rather have - earn net $1,465 or only $660?


Why does this work? The client uses, but doesn’t spend, the money to pay off the credit card, so compound interest is working its magic!


Get a home equity line of credit


Even if you don’t need it, a good strategy is to get a home equity line of credit just as an additional buffer to supplement any emergency fund you have.

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