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PAYING DOWN DEBT
Risk Reduction Approach Lenders categorize debt based on risk exposure and so should you. Even though your plan may be to totally eliminate all debt, plans change. Sometime in the future you may once again find yourself before a lender seeking another loan, maybe to refinance a loan at a better interest rate. Chances are good this will happen before your total debt elimination plan is fully realized. Prepare now for that likelihood by paying off high risk debt first to reduce your overall cumulative risk so lenders are more likely to grant you that future loan. Lenders first categorize debt as “secured” and “unsecured.” Secured debt is backed by collateral that the lender can repossess or foreclose upon should you cease to keep up your end of the bargain. This can be complicated as lenders further categorize secured debt based on the value of the collateral, how the collateral normally appreciates/depreciates, and the ability to resell it. For this reason, a well-maintained building is better
collateral than undeveloped land, and both are better than a vehicle which, in turn, is better than a boat. The better the collateral, the less risk associated with the debt. As you might suspect, unsecured debt is uncollateralized. It has nothing to back it up except your word that you will repay. Unsecured debt is, therefore, the most risky debt. Following through with the above example, using the Risk Reduction Approach–pay off the credit card first, followed by the vehicle loan, and then the mortgage. The Best Approach for You As you can see, each approach can produce a different answer as to which debt to reduce first. Unfortunately, just as there are no magic wands, there is not a best approach. All four approaches have great merit and can produce the “right answer.” In the end, it is you who must decide the prudent financial management solution to meet your goals.
Run through the analysis using each tool. Lay out the results for your particular situation. Balance what you find against your personal strengths and weaknesses while weighing in possible future scenarios. Then, make a decision! No decision you make to reduce debt will be wrong, it will just minimize your total interest paid, reduce the number of debts owed, add greater flexibility to your finances, or prepare you to seek another loan. Whatever decision you make, make it today. ABOUT THE AUTHOR Christian D. Malesic, MBA, IOM, is the Executive Officer of the Home Builders Association of Berks County. He provides insight on construction issues, business operations, marketing, personal finance, and occasionally, on political philosophy/ history. Contact Christian at the HBA of Berks County office: Christian@ HBAberks.org or, to receive notice of the newest articles written by Christian, follow him on Twitter @CDMalesic.
october 2013 AT HOME IN BERKs
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