Debt Elimination: Managing It Through Turbulent Times

 

Debt is a tool that must be smartly managed. Getting on top of it is the single most important financial step you can take. Here's how to do it.

The Business Cycle

To explore the fundamentals behind the historic, destructive forces wreaking havoc upon individuals, businesses and governments alike, one must understand the term business cycle. The business cycle is a characterization of the direction of economic activity within a broader economy. The five stages are as follows: expansion, peak, recession, trough, and recovery. According to Investopedia.com, the average post-World War II expansion has lasted 50 months, while the average contraction has been just eleven months.

During expansions, individuals, governments and businesses typically finance growth through the acquisition of significant amounts of additional debt. During contractions, the same parties attempt to reduce debt in order to mitigate uncertain or declining revenues. Needless to say, the former is far easier to accomplish than the later.

The Root Causes

During the roughly ten-year "greed is good" era between 1996-2006, the general world economy experienced a long, broad-based expansion, interrupted only briefly by the mild recession of 2002-03. The short recession was combated in the United States by the Federal Reserve reducing the overnight Fed funds rate six times in the 21 months following the September 11, 2001 attacks. The lowering of short-term rates triggered a corresponding reduction in mortgage rates, which in conjunction with low unemployment, reduced underwriting standards by lenders and other factors, fueled a real estate boom.

Starting in July, 2004 and lasting for the next two years, the Fed starting ratcheting up interest rates in an effort to thwart inflationary pressures and put a damper on excessive growth. However, with sub-prime lending in its heyday, the effort only served to invert the yield curve, as short-term rates were pushed higher than long-term rates, held low due to voracious demand. Real estate investment and speculation therefor continued nearly unabated until 2007 when the market finally peaked, and shortly thereafter, crashed.

The Net Result

The cratering of both the real estate market and the broader economy as a whole over the past three years has caused trillions of dollars of wealth to evaporate from financial statements. The global impacts will last for years to come, as asset values have seriously degraded while the debt has remained relatively constant. As a result, many borrowers are struggling to pay debts correlating with assets worth substantially less than they once were.

Psychology

First off, it's important to acknowledge the cyclicity of the economy and, as such, recognize the likelihood that if the assets in question have depreciated in value due to the global economy, they will eventually return at least some of their lost equity over time as the markets heal. Secondly, understand that although equity carries important psychological value, until it is leveraged or cashed in, it has no immediate financial value. Thirdly, if income remains constant, the ability to service the debt should be unimpeded. Lastly, realize that the obligor (you) have an absolute, dollar-for-dollar ability to create equity by doing nothing more than taking heed of your own personal cash flows.

Understanding Your Personal Cash Flows

It is vitally important that you understand your own cash flows — now. You do not need a finance degree to become keenly aware of your own situation. If you are not a spreadsheet-maker and if so desired, you can literally go low-tech by grabbing a pencil and paper.

List your monthly take-home income (A) and your monthly debt payments (B). Include only actual debt payments (such as credit cards, mortgage and car payments), not monthly operating expenses like food or electricity. Divide the debt payments by your take-home income. Ideally and as a benchmark, that ratio should be less than 40% of your take-home pay.

Go through the remainder of your non-debt expenses, which would include everything else: food, clothing, standard monthly bills, discretionary expenditures and the like. If you believe there are no items that would skew them artificially higher or lower, take a six-month average of what they have been historically (C) and throw that figure below the listed debt payments. If you can't track that far back, use at least a three-month average. Feel free to remove one-time expenditures that you are certain will not recur from your listed totals, but be very careful about doing so, as life throws plenty of curve balls and it is safer to assume there will be others down the line.

Now, subtract debt payments (B) plus all other expenses (C) from income (A). Is the number positive or negative?

If Positive

If the figure is positive, your personal cash flow should be generally in balance. More importantly, the positive number is a figure you can reasonably rely upon to put into savings or investments and/or against your debt, whether it be credit card balances, your car loan, a home equity line of credit or your mortgage. Without having to belt-tighten, you have the flexibility to create equity every month. Be aware that using an average as suggested above does not allow for monthly variances, so take that into account when you do your math.

Decide on a ratio that you believe is reasonable (50/50 is a good starting point) and follow through aggressively. Take half of the positive figure and put into savings or investments, and apply the other half as a principal reduction against one or more of your debts. Both will create dollar-for-dollar equity on your financial statement, as you will be left with an asset (cash) and/or reduced liabilities to show for the proactive application of your positive cash flow. Note: although paying higher-rate debts first makes investment sense, applying the extra against debts that will be retired soonest makes the most cash flow sense, as that creates permanent positive benefits. My recommendation is to do the latter.

If Negative

Obviously, this is a thornier issue, as it means you do not have sufficient income to cover your debts and monthly expenses. However, you now have a gauge as to how far behind you are going every month. In all likelihood, this is approximately how much your savings are being depleted or how much your debt is increasing on a monthly basis to cover the negative portion of your cash flow. Consider the following:

• Reduce your discretionary expenses every month by that amount, and preferably more. Typical discretionary items to target include dining out, "sin" expenses like beer, cigarettes, and other non-necessities, and recreational activities.
• Increase your income every month. In these times, this is a difficult solution, but if possible — whether it be a spouse going to work, obtaining or increasing additional income in other ways (overtime, a second job, changing your employment) — you can eliminate the negative portion of your cash flow through increased income.
• Refinance higher-payment obligations with a lower-payment option. Be careful here. You're trying to create equity, not trade debt. However, if you're in the negative, it is essential that you stop the bleeding.
• Ask family for assistance. Be very careful with this option. If utilized, borrow just enough to eliminate sufficient debt to get into the positive, and pay them back as soon as possible (no doubt they'll want that!)

As with the positive cash flow strategy above, your goal is to create equity. Stemming the negative tide will stop the monthly net outflow further eroding your net worth beyond what economic forces are already doing to your assets. You cannot control the latter, but you can control the former. Moreover, beyond just leveling off and to the extent possible, take one or more of these steps to create positive cash flow. Once accomplished, you can apply the excess into savings or against debt as suggested above to create equity on your financial statement on a monthly basis.

Summary

It's not too late to fix your personal finances. To repair the damage, you need to be aware of what happened, why it happened, and the steps you need to take to solve the problem. Once you've taken stock of your own financial situation, discipline yourself to create positive personal cash flow and begin applying the excess as principal reductions against debt, into savings, or a combination of the two, every single month. Think of it as another bill that must be paid, but now you're paying yourself.

Before long, you'll find that your personal finances are under firm control and you're beginning to create equity. The process may be slow, but it will add up over time and it's wholly within your control — you're in charge. And all you needed was a pencil and paper along with a bit of self-discipline. That's not too much to ask of your favorite boss.

Sources:

• Investopedia.com
• WSJ.com
• WashingtonPost.com
• Economist.com
• Budgeting Suite 101