The ongoing COVID-19 recession has made personal finance top-of-mind for many Americans. While many are facing profound financial strain from rising unemployment, others who were fortunate enough to adapt into remote work saw little, if any, reduction in income. And with fewer opportunities for travel and entertainment, some are even finding more money in their pockets than they had anticipated.
While proactive debt management should play a major role in the financial plans of people in both groups, those who have seen their financial situation improve during the pandemic have a unique opportunity with historically low interest rates to refinance debt and refocus cash flow. Here are some strategies to get you started in navigating debt management.
Gather data about your debt and finances
Before you can take any action, you first need to understand critical pieces of information about all your debts, such as: What type of debt is it? Is it secured or unsecured? What are the interest rates and required minimum payments? Aggregation software such as Mint can be helpful here as well.
Once you have a clearer view of your debt landscape, you should then adopt a debt management strategy. Broadly speaking, you must decide whether to focus on refinancing, repayment or whether to drag out payments as long as possible. The best path depends on the type of debt as well as your particular financial situation.
Option No. 1: Refinance Your Debt
During recessions, central banks lower interest rates to encourage spending and borrowing. These efforts also present people who have existing debt the opportunity to refinance. Debt refinancing is often a good strategy for people with high credit scores and large amounts of higher-interest debt.
The purpose of refinancing is to lower interest rates or extend the length of a loan’s term. The larger a debt, the more impactful refinancing is. Consider the case of a 20-year mortgage and a refinancing opportunity that reduces the interest rate from 4.5% to 3%. On a $400,000 loan, this will reduce the monthly payment from $2,531 to $2,218 a month – a monthly savings of $313.
Student loan refinancing can also create large monthly savings. Refinancing from 10% to 3% could save a borrower with $100,000 in loans over $350 a month over a 10-year repayment. And many companies now offer benefits formerly offered only by federally serviced loans, such as the ability to defer payments in the event of a job loss.
For credit card debt, balance-transfer credit cards can also help reduce monthly payments and overall interest charges. A borrower can transfer the existing balance on a high-interest credit card to a new card with a lower interest rate, which saves on interest.
Keep in mind that because refinancing usually increases the principal owed, it may be better for people with relatively small loan balances to just stick with their current repayment plan.
Option No. 2: Prioritize Debt Repayment
Borrowers may prefer to redirect cash flow toward paying down their balances. This option works best for people with high incomes, cash on the side, and smaller debts. And because the COVID-19 pandemic limits spending options, a borrower who takes that freed-up cash and spends it on debt won’t “feel it” in the same way they might if they could go out and spend more.
For borrowers with many debts, which should be paid off first? One school of thought suggests borrowers should make extra payments on their smallest debts first to chip away at quick wins. Another method is to pay off debts with the highest interest rates first to save the most on interest payments.
Whichever method you choose, loop your lender in. Especially during economic downturns, lenders are concerned about defaults — so most will be willing to work with borrowers to set up the most prudent repayment plans.
Option No. 3: Drag Out Your Debts
While most people don’t like being in debt, there are times when staying in low-interest debt is the best way to increase long-term net worth.
There is no hard, fast rule on which debts you should prioritize paying down and which you should just make minimum payments on. Generally, the lower the interest rate, the better it is to make only minimum payments. For example, say you refinanced your mortgage and student loans down to a rate of less than 3%, and you invest your excess cash in a diversified investment fund instead of paying down your debt. In the long run, this investment can average a return above 7%. While you pay 3% in interest, you can make 7% on money you would have otherwise sent to a lender. Over many years, that difference can turn into a very large nest egg.
Concluding Thoughts
This year has been challenging for just about everyone. If you’re looking for silver linings, you may be able to take advantage of this year’s low interest rates and reduced expenses to refinance your debt or pay off debt more quickly.
Eventually, this year will be in the rearview mirror, and smart debt management moves now can put you ahead in the game toward a brighter financial future.
(SOURCE: TCA)
(Article written by Kiplinger)
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