Reducing the Cost of Debt

As the old adage goes: "A penny saved is a penny earned." And though it may sound trite, it is true. If you carry a large amount of debt, one of the easiest ways to reduce spending is to reduce the ongoing amount you must pay in interest on that debt. There are several ways to reduce the cost of debt, each of which have both positive and negative aspects. You can implement one or a combination of them, depending on the amount and type of debt you are carrying.

If you are currently making payments on a high-interest consumer loan, such as a mortgage or auto loan, and interest rates have come down since you originally borrowed the money, refinancing may be a good idea.

If you refinance to a lower interest rate, your monthly payment will likely be lower. You might choose to extend the loan term as well, which can substantially lower your monthly payment. If you are refinancing your mortgage, you may be able to do a cash-out refinance, which allows you to borrow more than you currently owe on your home. You can then use the additional cash to pay off other high interest debts, and the interest is generally tax deductible.

However, refinancing also involves its own costs, and you should factor them into your calculations of how much refinancing might save you. You will probably have to pay points and closing costs if you refinance your mortgage. These could significantly reduce the amount you save by refinancing at a lower interest rate. Also, extending the term of any loan will increase the total amount of interest you pay over the loan's life. Finally, be careful about doing what's called a cash-out refinance (refinancing that lets you convert part of the equity in your home to cash). First, it can increase the size of your mortgage, which may actually increase your debt rather than reducing it. That can be risky, because your home is the collateral for this loan. If you are unable to repay the loan as promised, the lender can foreclose on your home and sell it to pay off your debt. Second, a cash-out refinance that increases your debt can become problematic if home values fall. Some homeowners in the past who did cash-out refinancings have run into problems when lower home values left their homes worth less than they owed on the refinanced mortgage.

Debt consolidation basically means rolling multiple small individual loans into one larger loan. This allows you to make only one monthly payment instead of many. There are many ways to consolidate loans, including rolling them into one low-interest credit card, taking out a personal loan to pay off your debts (if they aren't excessive), or using a home equity loan (see below). There are both positive and negative aspects to this method of reducing the cost of debt.

• Consolidation makes your bill-paying task simpler. Because all your loans are combined, you have only one monthly payment. Additionally, the monthly payment on your consolidation loan should be less than the sum of the monthly payments on your individual loans. If this is not the case, consolidation may not be your best option.

• The interest rate on your consolidation loan (regardless of what type of loan you take) should be lower than the average of the interest rates on your individual loans. This would not only lower your monthly payment but save you money over time.

• As discussed below, using a home equity loan to consolidate your debts can be dangerous because your home is collateral for the loan. If you fail to repay the loan as promised, the lender can foreclose on your home and sell it to pay off your loan.

• The interest you pay on consolidation loans (other than home equity loans) is not tax deductible. For example, if you roll your debts onto one low-interest credit card, you cannot deduct the interest you pay on that credit card.

• If the term of your consolidation loan is longer than the terms of the original loans, you may end up paying more interest in the long run, even if the rate is lower. In that case, you may not actually be saving any money, even though your monthly payments might be less. Additionally, using a long-term loan to consolidate your debts means you could be paying for minor purchases for a long time to come. Do you really want to take 15 years to pay off the anniversary dinner you charged last month?

The best way to deal with credit card debt is to pay it off in full each month. However, that's not always possible. There are some other things you can do to help lower the cost of your credit cards. Comparing credit card finance charges, fees, and benefits may help you minimize your interest rate and annual fees. And of course, paying off outstanding balances reduces not only the interest you pay each month but the total interest you pay over the long term.

You can borrow against the equity in your home by taking a home equity loan or line of credit. Using a home equity loan or line of credit to pay off other debt has both advantages and disadvantages.

• The interest rate you pay on a home equity loan or line of credit will likely be lower than the rate you pay on credit cards and other unsecured consumer debt. In addition, you generally receive a home mortgage interest deduction for interest on home equity financing. By using a home equity loan or line of credit to pay off credit card and other debt, you are effectively converting nondeductible interest to deductible interest.

• Interest rates for home equity financing may be higher than those for education loans and some auto loans. In addition, while a home equity loan usually carries a fixed rate of interest, a home equity line of credit often has an adjustable rate. If this rate later goes up, the increase could offset the advantages of using a home equity line of credit to pay off these other, fixed-interest debts.

• Like credit cards, it is easy to abuse your home equity loan (especially home equity lines of credit) by running up large debts. This is especially true for disposable consumer items, such as clothing and food. These items are relatively inexpensive and may soon be used up and discarded. However, if you use your home equity loan or line of credit to buy them, you could still be paying for them many years later.

• Many home equity lines of credit have very low minimum payments, often requiring that you pay only interest plus a nominal amount of principal each month. However, the loan will have to be paid back in full within 15 years, and often much sooner. The danger is that, when your loan comes due, you won't have the funds needed to pay it off.

• Most importantly, your home equity loan or line of credit will be secured by a lien on your home. So, unlike credit cards and other consumer debt, if you can't make the payment on your loan and end up defaulting, the lender can foreclose on your home.

You may choose to withdraw funds from other investment vehicles in order to pay down your debt, for example, you might tap a vacation savings account--or you might sell off some of your current assets, such as stocks, bonds, jewelry, or fine art. For example, if you have stocks that have experienced losses and you no longer want them in your portfolio, selling them and using the proceeds to reduce your debt burden could in effect help offset some of the cost of your investment loss. Assets that are no longer needed, or that have lost any special meaning, can be sold for cash, and the proceeds used to pay down debt. These options hold certain unique advantages. However, there may be tax consequences and other disadvantages, as well.

• If you tap into the right assets, you may be able to raise the necessary cash without decreasing your liquidity. This means your ability to take advantage of unexpected investment opportunities would be unchanged. You should not touch any assets that you have designated as part of your cash reserve. Designating money or credit for a cash reserve means that you recognize its special function as your "emergency fund," even if it is not isolated in a special cash reserve account.

• If you'll have to sell capital assets, such as stock or mutual funds, to pay off debt, you must take into account the capital gains tax you may owe on the assets sold. In many cases, this tax could eliminate the advantage of paying off a debt.

Tip: Depending on the reason for paying off the debt, it may be worthwhile to take a possible tax hit (for example, if you have a mortgage or auto loan that is in default).

• As mentioned above, you should not dig into your cash reserve to pay off your debts. Many experts recommend keeping 3-6 months of living expenses in readily accessible form to be used in case of financial emergency. In most cases, reducing the cost of debt is an ongoing process rather than an immediate emergency.

You might think it's a good idea to prepay a debt if you have the resources to do so. However, this is not always the case. Prepaying debt has both advantages and disadvantages.

• Real estate loans are generally amortized, meaning that most of your monthly payment is applied toward interest on the loan at the beginning of the its term, while the bulk of the loan's principal is repaid toward the end. Paying off the loan early (either using a lump-sum payment or paying a little extra every month) will quickly decrease the principal balance owed on the loan, build up "equity" more quickly, and shorten the term of the loan. The result is that you'll save a great deal on the amount of interest you ultimately pay on the loan.

• Prepaying your loans means your funds are not available for other purposes. Although you are building equity, you are reducing your liquidity. If an unexpected investment opportunity were to come up--for example, one that might earn more than the interest you save by prepayingor you suddenly had a financial emergency, you might not have the cash available to deal with the situation.

• In some instances, a lender may charge a prepayment penalty. In such cases, you must calculate whether the amount you save from prepayment will exceed the penalty amount. Prepayment penalties can also be "hidden" in the method of interest calculation. For example, the Rule of 78s (see below) allows lenders to charge more interest in the early stages of a loan. This interest is not refunded if you repay the loan early.

• If you prepay your home mortgage, you can lose a valuable home mortgage interest deduction on your income taxes. Also, there may be other ways to accomplish the same goal, such as making biweekly mortgage payments.

• Prepayment does not change your obligation to make regular monthly payments. If you send in double payments for three months, you are still required to make a regular payment the next month. Be careful not to prepay so much that you can't afford your regular monthly payment.

The Rule of 78s (also called the sum-of-the-year's-digits method) is a method of calculating interest that is used by some lenders on certain installment loans. When this method is used, you pay more interest in the early months of the loan. The reason this method is used is because the lender argues that the uncertainty created about an early payoff entitles the lender to some compensation for being at the borrower's mercy for an early payoff.

Using the Rule of 78s formula, interest for each month is calculated as a fraction of the total interest to be paid. This is done by first adding up the digits that represent the number of months in the loan term. For a one-year loan, the total is 78 (1+2+3+4+5...+12 = 78). The first month's interest would be 12/78 of the total finance charge, the second month's interest would be 11/78 of the total finance charge, and so on. If you paid off a one-year loan in six months using this method of interest calculation, you would pay 57/78, or 73 percent of the total interest (12+11+10+9+8+7 = 57). The formula works the same for a loan of any length. For a two-year loan, the sum of the year's digits is 300 (1+2+3+4+5...+24 = 300). The first month's interest would be 24/300 of the total finance charge and so on.

Because this method favors the lender if you prepay the loan, it is often said to contain a "hidden" prepayment penalty. Accordingly, before paying off consumer loans on which interest is calculated via the Rule of 78s, check with your financial professional first to determine exactly how much interest you will save and whether prepaying this debt is advisable.