How To Tackle A Large Debt

by Neil Faulkner on 04 July 2008  |  23 comments
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If you can afford your minimum payments then you can actually pay more than the minimum without spending an extra penny! Neil Faulkner makes you think Foolishly about your debt repayments.

From late 2005 to June 2007, the growth in unsecured debts -- such as credit-cards -- gradually fell. The annual growth rate fell from an incredible high of 14% to less than 6%. Since credit crunched last July, it has turned sharply to rise to 8%.

Credit Action reports that for those of us with some form of unsecured debt, the average debt is almost £22,000. You could easily be spending £2,000 to £3,000 on interest payments alone each year.

If our unsecured debt continues to rise by 8%, that £22,000 will rise to £23,760. This means that next year your repayments, and the interest you're charged, will climb further.

What can you do?

To start reducing your debts you must pay more than the minimum repayment. Paying just the minimum is what kills you. You might be thinking: `I'm an average person with an average debt: about £22,000. How on Earth can I afford more than the minimum? I can only just afford the minimum as it is!'

Well:

If you can afford the minimum payment this month, you can afford to overpay next month.

This is how it works. The minimum will hopefully be no lower than 2%, which is too low in my opinion. However, 2% should still be high enough to pay off all the interest you're charged each month, and it'll reduce your debt just a little.

Let's say that you sensibly target your most expensive credit card (which is the one with the highest interest rate). This card has £10,000 of debt on it and charges 16% APR. In the first month you pay the minimum 2%, which is £200. However, you're also charged £133.33 in interest, so your debt goes down a depressingly small £67.33 to £9,933.33.

The next month you pay 2% again. This time the minimum payment is slightly lower at £198.67. However, your debt goes down less too, by just £66.22. In fact, each month you'll reduce your debt by less and less. At this rate, it'll take you 50 years to clear your debt.

The longer you have your debt, the more you'll pay in interest, and the less stuff you'll be able to buy in your lifetime.

Fix your repayment

So let's back up a step. Remember you said you could barely afford the minimum payment? Well that was £200 in the first month. If you can afford £200 this month, you can afford £200 next month, right? So in the second month you can already afford more than the minimum payment. What effect will this have on your debt? And why am I asking so many rhetorical questions in today's article?

Let's say then that you fix your repayments at £200. In the second month you decrease your debt by £67.55. If you remember, you reduced it by £66.67 in the first month, so your debt is now going down a few pence faster, rather than a few pence slower as happened when you were paying 2% each month.

What difference does that extra 88 pence make? Not much, but in the third month you pay £200 again and your debt goes down by £68.46, or £1.79 more; in the fourth month by £69.37, which is £2.70 more. By the twelfth month your debt is going down more than £10 per month faster. This keeps growing and growing. What's more, it grows more rapidly each month.

A three-year plan

Three years is a nice time to plan for. Any further in the future is too hard to see. Any shorter and you probably won't see a noticeable difference in your debts - not when your starting point is just 2%. It's also a suitably long plan for any of you who are seriously attempting to reduce your debts.

After three years, your £200 payment will reduce your debt by £105.98, which is approaching £40 more off your debt each month than when you started.

This will continue to accelerate until you've cleared your debt in seven years: seven times faster than if you paid just the minimum. The total interest you pay is £6,700, compared to the £19,300 you'd pay with just the minimums.

So yes, it'll still take seven years overall to clear the debt, but hopefully you'll have got the dealing with debt bug by now and are willing to attempt a more ambitious target to clear your debt even faster.

After you've cleared your most expensive debt, you then throw all that £200 at the next debt and clear it in the same way.

I recommend you ask our Dealing with Debt board users what you can do about your debts. Ensure they realise the question isn't rhetorical!

Here are some more recent articles that I think might interest you:

The Best Ways To Get Out Of Debt

7 Tips To Seriously Reduce Your Debts

> Get a cheaper loan or credit card, as that could shave years off of your debts!