How Debt Management Helps You Eliminate Debt Faster
Author: Anthony Manganiello
Author of The Debt-FREE Millionaire and creator of www.DebtFreeAcademy.com
Debt management programs typically involve establishing a new arrangement between you and your creditors, which usually results the program lowering the interest rates on your accounts. This, in turn, should lower your payments. Once the program starts, you begin to issue payments to the debt management company, and they in turn distribute those payments to your creditors.
The magic, if there is any, to a debt management program (sometimes referred to as a debt consolidation program) is how lower interest rates make it possible to eliminate those accounts much faster, even with lower payments. This is how it works.
One thing you need to understand about credit card debt is that the interest for each payment is calculated differently then interest on something like a car loan or mortgage. Mortgages and car loans use something called “simple interest” while credit cards use something called “revolving interest.” This is because, with a credit card, the balance due can change from month to month. A credit card issues you a “line of credit” that you can use and will most likely fluctuate from one billing period to the next, whereas, a mortgage or car loan has a fixed balance.
What this means is that the interest due for each payment is recalculated each month based on the balance due for that particular billing period.
Let’s take an example of one credit card account with a limit of $7,000, an outstanding balance of $5,000, an annual interest rate of 19.5%, and a minimum payment of $175 per month. Here’s a rough idea of how your payment will be applied:
DISCLAIMER: This is somewhat of an oversimplification of the process. There may be additional calculations included when your actual creditor determines how payments are calculated and applied, as well as with how debt management programs determine these numbers. However, you should get the idea…
- Interest for that month = $81.25 (this amount comes from multiplying the balance – or $5,000 by the annual interest rate – or 19.5% – and then dividing that amount by 12 to prorate the interest for THAT month).
- Principal for that month = $93.75 (this comes from subtracting the interest – or $81.25 from the minimum monthly payment of $175).
- Remaining balance carried over to the next month = $4,906.25 ($5,000 minus the $93.75 that was applied towards principal reduction).
If you don’t use that card at all between this billing period and the next, the above calculations will repeat themselves starting with the new $4,906.25 balance.
However, let’s say you decide to enroll into a debt management program, and the service provider secures a lower interest rate for you of say – 8%. Additionally, they’re able to lower your payment to $150. Let’s take a look at how these numbers break down now:
- Interest for that month = $33.33 (this amount comes from multiplying the balance – or $5,000 by the annual interest rate – or 8% – and then dividing that amount by 12 to prorate the interest for THAT month).
- Principal for that month = $116.67 (this comes from subtracting the interest – or $33.33 from the minimum monthly payment of $150).
- Remaining balance carried over to the next month = $4,883.33
Do you see how, even with a lower monthly payment (in this case the debt management service is saving you $25 a month), you’re ending balance for that month is lower? This is because – by lowering the interest rate (from 19.5 to 8 percent in the above example) – a much larger portion of even the lower payment is applied towards the principal. This has a significant impact on how fast each debt is paid off.
By increasing the principal reduction you decrease the amount of time it would take to pay off credit card debt.
Another key is that while on a debt management program, your payment each month typically remains the same from month to month. In our example, the new, lower payment, of $150 is the payment towards that account for the duration of the program.
Contrast that with a decreasing minimum payment the credit card company would require due to the decreasing balance (assuming no new charges were made to that account).
On a debt management program, the combination of lower interest rates, and consistent minimum payments, has a powerful impact on principal reduction. The result is the ability to pay off those debt balances years faster than if you continued to make just the minimum monthly payment required by the credit card company.