Many people don’t put too much thought into what their monthly payments should be like. Oftentimes, they just pay the minimum payment when they could afford to pay more.
Sometimes, the most obvious strategy towards debt repayments is not always the best.
That’s why today, I’ll be discussing how you can develop the most effective strategy to pay off debts so that you can save both your money as well as your time.
Why is Paying the Minimum Payment Every Time a Bad Idea?
If the minimum payment for a certain debt is all that you can afford, then you don’t really have a choice.
On the other hand, if you can afford to make a larger payment but you’re still making the minimum payment, this is never good.
This is because you’re charged interest on your debt repayments.
Making the minimum payment every time would mean that your debt repayments would go on for a much longer time. This would mean that you would pay a much larger amount of money in the form of interest.
If you were to make larger payments and finished your debt repayment earlier, then you would have paid a relatively smaller amount of money in the form of interest.
Thus, if you can afford to, it’s always a good idea to pay more than what the minimum payment is when it comes to debt payments.
Persistent Debt and Credit Cards
Another important reason why you should avoid making minimum payments to creditors is the fact that you could run the risk of being stuck in persistent debt.
As the name suggests, persistent debt refers to debt that does not get paid off despite you making payments to it.
This is because the rate at which you’re paying back your debt is lower than the rate at which the debt is increasing due to interest.
This typically happens with the outstanding balance on credit cards and if you happen to get stuck in persistent debt, you will most likely receive a letter from your credit card company.
You can then discuss strategies with them to get yourself out of persistent debt. This could be through them giving you a payment break or it could be through them lowering your interest rate.
How do I Prioritise Debts in My Repayment Plan?
Debt Management Plan (DMP)
When it comes to a DMP, you’re only dealing with unsecured debts.
If your DMP is being handled by a third party such as a debt charity, then they’re the ones who will be responsible for distributing your payments among your creditors. You won’t have to worry about which creditor gets what amount. You just have to make a single payment to the debt charity.
On the other hand, if you’re managing your DMP on your own, then you’re the one who’s going to distribute the money among your creditors.
The division of your monthly payment among your creditors will depend on how much debt you owe to each of them.
For example, if you owe a certain creditor 40% of your total debt, then that creditor will receive 40% of your monthly payment.
Debt Repayment Plan
If your monthly repayments are not part of a DMP and you’re just making an informal debt repayment plan on your own, then there are some more aspects that you’ll have to take into account.
The first thing you’ll be addressing is priority debts. Priority debts, as the name implies, are debts that need to be attended to first. This is because if you fall behind on their monthly repayments, then this could lead to severe consequences.
An example of a priority debt would be a mortgage loan. If you start missing payments towards your mortgage loan, then you could lose your home.
Once you’ve accounted for the priority/secured debts that you have, it’s time to take a look at your unsecured debts.
Prioritising unsecured debts can seem confusing since they may seem indistinguishable from one another. However, there’s one aspect that you can use to distinguish them: their interest rates.
When you’re thinking about which unsecured debt to prioritise, it’s usually a good idea to prioritise the one with the highest interest rate. Thus, it would be your aim to pay off the unsecured debt with the highest interest rate first.
Again, it’s a good idea to pay off the debt with the highest interest rate first because then you would be paying the least possible amount in the form of interest to your creditors.
Credit card debt is an example of unsecured debt that usually has very high interest rates.
Calculating Surplus Income
Your surplus income (or disposable income) can be defined as the amount of cash that is left over once you have attended to all of your essential monthly living costs.
Calculating your surplus income is essential when determining what your monthly repayments are going to look like as this will be the amount that you have at your disposal to make those payments.
The first step to calculating your surplus income is to first calculate your regular income. Make sure that you include all avenues of revenue and add them up.
If you’re self-employed, this can be tougher to do than if you’re a traditional employee.
In the case of self-employment, you can look at what your income was for the past 6 – 12 months and take their average in order to get an approximate amount.
Once you have your income amount, it’s time to calculate what your monthly essential living costs are. This can also be tricky if you don’t normally keep track of your expenses. Looking up old bank account statements and receipts can be a good idea of documenting where your cash is being spent every month.
When you’ve calculated your income and your essential monthly costs, you can subtract the latter from the former to calculate your surplus income.
This is the amount that you will use to make your payment every month to creditors.
Once you’ve made a payment plan, you should write to each creditor and inform them of it.
It’s a good idea to enclose a copy of your budget which proves that you’re only paying for essential living costs while the rest is going towards payments for your debts.
In your letter to each creditor, you should:
- Explain why you’ve been having trouble making payments. For example, if you were ill or if you’ve lost your job
- Elaborate on what steps you’re taking to improve your situation. For example, if you’re seeking debt advice from a debt charity or if you’re opting for a debt solution such as a debt relief order
- Tell them how much you can afford to contribute each month (if you intend on paying and are not opting for a debt solution that writes off your debts)
- Request them to freeze interest and additional charges on your payments as long as you continue to pay the amount you’ve mentioned in your letter.
If a creditor refuses to accept your payment offer, you should write to them again and inform them that this is all you can afford. Make sure to enclose a copy of your financial statement.
Never be pressured into paying more than you can afford. Not only will this be a great source of mental stress but it may also propel you into an even worse financial situation.
If the creditor still refuses, start making payments to them anyway and inform them that you’re doing so.
If other creditors have accepted your payment offers, point this out to the creditor as well.
They have professionals who might be able to negotiate with the creditor on your behalf.
Calculating your monthly payments is a crucial part of ensuring your debts get paid off effectively.
It’s important to strike a balance between what’s affordable to you and what’s acceptable to your creditor(s).