The laws of the universe are some of the most basic truths. One law I recall from my school days was created by Sir Isaac Newton, and states: For every action, there is an equal but opposite reaction. It seems this can be applied to the Christmas season for many individuals. Their generosity to others and themselves, will be the basis for the size and quantity of their credit card statements in January.
If this describes your Christmas, and the equal but opposite reaction of the credit card statements, then it may be time for you to make a change. Spending future income now is one sure way to always remain in debt and rarely create wealth. By carrying debt, not only are you using future income now, but you also have to increase your payments for the cost of borrowing future income and that is the interest you are paying.
I know some of you are very clever at keeping the interest costs low. Through special deals by the credit card companies or transferring balances to new cards with the promise of a low fixed rate until the balance is paid. While you have worked hard to keep the interest rates low, the amount of interest and the overall size of the payments can severely reduce what is available from your current income to meet current expenses. It seems there is always an unexpected cost that will cause even more of your current expenses to be paid by future income. To break this cycle and start the creating wealth, you must first start to live within your means. This is a very simple statement, but one that often is very hard to do. By calculating your expected take home for each month and then subtracting from that amount the minimum payments required on your debt, you have your net available for current expenses. Hopefully, this amount is actually larger than your monthly required spending such as utilities, rent or mortgage payment, gas, and food.
Once you have reduced the net available by the amount of your fixed mandatory expenses, you will have the discretionary spending amount. This is the amount of your monthly income you can spend however you want. You have the choice. Based upon how fast you would like to be out of debt will be the basis of how much of this discretionary spending amount we will use to pay over and above the minimum payments on your debt. Be sure not to use 100 percent, as few individuals can go months of depriving themselves of a few luxuries. Once you know the amount of additional funds you are going to pay on your debt that is over and above the minimum payments, you must now decide where the extra funds will be applied. My preference would be to apply the extra funds to the smallest debts first. Once the smallest debt is paid off, you have achieved two successes. The elimination of one creditor by paying them off, and you have freed up part of your monthly income because you no longer have to pay one of the minimum payment amounts. This will allow you to increase the amount of the extra payments on the next debt you focus on paying off.
Once all of the small balances are paid off, and the remaining balances to each lender are about the same, then you can shift the strategy from paying the small balances to paying the lenders charging you the highest interest rate. While this may sound simple, the promotional rates and special deals can often make it impossible to direct your payment to the portion of your debt that is being charged the high interest rate.
All credit card companies apply each payment you make in a very specific order. If there is a fee on the account such as an over-limit charge or annual renewal fee, your payment first goes to pay the fee. The balance of your payment is then applied to the interest charged on the account. If there is still a portion of your payment not yet allocated, it will then be applied to your principle.
Each amount listed on your statement is segregated based upon the interest rate that portion is being charged. Therefore, if you have a five thousand dollar balance of which two thousand was a transfer balance at a promotional rate of 2 percent, and the remaining balance were current charges on the account, they most likely are being charged your normal interest rate which may be anywhere from 9 percent to 21percent or more depending upon your credit. The credit card company applies any principle payments to the portion of your debt that is being charged the lowest interest rate. This allows the credit card company to maximize their income. So while you may believe you are paying on your debt being charged the highest interest rate, you should review your credit card balances to make sure your payments are not being applied to a low or zero interest portion first.
HOW TO REACH THE WRITER
Would you like a response to a financial question? Send your question to Doug Horn, 115 W. Broadway, Maryville, TN 37801. Be sure to mark your envelope Money Matters.
Doug Horn, CFP, is an area financial planner with more than 24 years financial experience and founder of Quality Financial Concepts, located in downtown Maryville on Broadway.
Doug Horn, CFP, Registered Investment Advisor in Tennessee and Texas and Registered Principal, Branch Office of and Securities offered through CUE Financial, Member FINRA, SIPC.