Choose Wisely when Managing Your Debts

Physician's Money Digest, February29 2004, Volume 11, Issue 4

If you had a choice between two lectures, one onhow to make 20% in the stock market this yearand another on how to reduce your high-interestdebt, you would probably rather listen to the oneabout stocks. After all, making money is a pleasant subject,and dealing with debt isn't. Unfortunately, this iswhere many physicians fail to meet their goals. To managedebt effectively, you need to understand what stepsare best for you to take.

Understand Your Wealth

The problem:

From an individual investor's perspective, wealthusually means how much you own, such as your house,cars, furniture, and clothes. But if the house has a mortgage,the cars are leased, and the furniture and clotheswere bought with credit cards that are yet to be paid off,you really don't own these things. The truth is, you'rejust borrowing most of your possessions from financiers. Since someone who's surrounded by nicethings is perceived to be wealthy, we have developed asense that creating wealth is accumulating assets.

The only way to create wealth is to understand andprioritize your debt. If you were faced with the opportunityto purchase an investment that would return 15%over the next year or to put that money toward a creditcard balance with a 21% annual interest rate, paying thedebt would increase your wealth more than the investmentwould. You just don't sense the same thrill.

Avoid Bad Deals

Clearly, credit card debt with a 21% interest rateis a bad deal. Nevertheless, 70% of consumers carrysome credit card debt. Adding to the impact is thatmost people aren't putting as much as they shouldtoward paying down the debt. It's more common tofind people putting extra money toward prepaying8% mortgages, while carrying credit card balancescosting them around 20%. These people are unknowinglyreducing their wealth each month.

Reducing your interest rates is an important stepin managing debt. Find a low-interest credit card andtransfer the balance from your high-interest card.Create a payment program that eliminates debt beforethe introductory period is up and the new card's rateincreases. Avoid transferring the balance to a newcard every 6 months, as it only works to drive downyour credit score.

Before you sink any deeper into debt, calculate thefollowing ratios to see where you stand:

• Monthly debt ratio. Add up all of your monthlypayments on consumer debt—including credit cards,lease payments, and loans—and divide that by yourmonthly take-home pay. If that number is in theneighborhood of 15%, you're pushing the envelope,and if it goes to 20%, you have problems.

• Total debt ratio. Add your housing costs to theconsumer debt payments. If the figure is 40% or less,your debt is manageable, but if it exceeds 50%, you'reon thin ice.

Get Out from Under

If you're in over your head in debt, then begin arecovery plan immediately. Shift all availableresources toward the debt with the highest interest,even if it means making minimum payments on everythingelse. If you still can't make the payments, contactyour creditors and request a payment plan.Collecting debt is expensive—lenders pay collectors10% or more of the amount collected as a fee. They'drather receive something every month directly fromyou without having to pay someone, even if it meansgiving you better terms.

Above all, don't dodge the issue, even if the lendercalls you. Show from the start that you are responsibleand willing to make every effort to satisfy yourdebts.