How to reduce the cost of your debt

Your ability to save money can become compromised by the financial
obligations you are paying in your life. If you have a mortgage and
consumer debts, this article will help you determine: Should you stay
the course or take action to start getting control of your cash?

The nuts and bolts of a good financial plan includes having
“preferred debt”. Preferred debt is tax-deductible (a mortgage) and has
no consumer obligations that are non-preferred (i.e. credit cards,
student loans, car payments, etc.). Non-preferred obligations will
compromise your ability to save money.

Consider the following scenario:

John Borrower has a mortgage of $300,000 with an interest rate of
3.875%. His mortgage is a 30-year fixed rate loan and his monthly
interest payments are $1,410.71. John also has a car loan of $10,000
with an interest rate of 6% and a monthly payment of $500. His credit
cards total $8,000 with an average interest rate of 16% on which he has
to pay $400 per month.

John Borrower has a great credit score because he always carried a
balance on his credit cards, has never missed a payment, and his credit
history is squeaky clean. However, John’s car just broke down and he
needs a new transmission that will cost him $3,500. Unfortunately,
John’s mortgage payment and other obligations take up a majority of his
income and now he has very little money saved up.

What does John do? He turns to his credit cards and goes further into
debt. He is reluctant to make any changes to his financial burden. He
has a great interest rate on his mortgage, but is he really getting
ahead financially?

There is a more proactive approach that John can take that will be
more consistent with having a strong financial foundation that will not
only make him more credit worthy, but will also give him the ability to
save and plan for the future.

The first thing to look at is all of John’s interest rates. True, his
mortgage rate is low but the weighted average of his interest rates on
all obligations is quite high. His interest payments alone take up a lot
of extra money. Let’s look at the math:

Debt

Balance

Interest Rate

Monthly Interest Payment

Bank of Bank Mortgage

$300,000.00

3.875%

$968.75

Car Lots Mega Car Loans

$10,000.00

6.000%

$50.00

Credit Cards (BULK)

$11,500.00

16.000%

$153.33

The total amount John owes in debts is $321,500, which includes his
new credit debt of $3,500 from the new transmission. If you multiply
John’s amount owed by each individual interest rate and add it together,
John is paying a total of $14,065.00 in interest alone each year.

Broken down: ($300,000*3.875%) + ($10,000*6%) + ($11,500*16%) = $14,065.00 (annual interest paid)

Dividing the yearly interest paid ($14,065) by the total amount owed
($321,500) results in John paying an annual average interest rate of
4.375%.

If John were to refinance his current mortgage at that average 4.375%
interest rate, something really interesting would happen to his
payments. John is currently paying $2,310.71 each month in debt payments
while interest is being accrued on his debts. By combining his debts
under one mortgage at the 4.375% interest rate over a 30-year fixed-rate
term, his monthly payments, interest included, would drop his payments
to $1,605.20 each month.

Say what?

If John refinances his mortgage for the purpose of “debt
consolidation”, his average interest rate does not change AND his
monthly payments are lowered. Suddenly, John Borrower is saving $705.51
each month. John can take that money and invest it or start a vacation
fund. He can also put it to the side in case something else on his car
breaks down. Regardless of his plans for the savings, the fact is that
he is saving money and gaining control of his cash flow.

Having low rates and high rates on multiple forms of debts probably
means you are going to be paying a higher rate of blended debt on all of
your preferred and non-preferred obligations over time. The reality is
that you can save through consolidation and fixing on one lower rate. It
might be higher than your current lowest rate, but as John discovered,
he could save money by increasing his lowest rate and combining his
debts.

The ideal financial scenario for any borrower is to have a single
mortgage payment with no debt obligations and to have at least 6 to 12
months of savings (“reserves”) to be used as “back up”. This financial
platform increases your borrowing power and is optimal for having a
choice and control over your funds.

If you are thinking about taking out a mortgage or making some
financial adjustments in your life, work with a lender who has the skill
set and ability to really investigate your debts and can show you the
real breakdown of your debts and what you are paying over time. You
might end up realizing how much control you are missing out on by having
payment obligations in an ongoing debt cycle. The numbers might astonish you.