Client Situation
Melissa is a 34-year-old creative director earning $21,000 per month. She has been struggling to keep up with several debts to which she recently added a maxed-out credit card from Christmas shopping.
On the January 9, Melissa met with her banker who offered to consolidate everything into one lower monthly payment of $5,500. The term of the loan is six years with an interest rate of 13 per cent APR (annual percentage rate). The lender plans to hold (as collateral) her car, valued at $100,000 plus a fixed deposit of $65,000 earning 0.08 per cent per annum.
See table for details of her debts
While she owes her father a significant amount of money, he has not put any demands on her and even offered to clear all of her debts. Melissa feels very badly about taking seven years to pay him back and couldn’t bear the thought of how long it would take if she added more money onto this figure. She is anxious to make a decision before her January month’s end salary so she can save the extra $3,000 every month towards the downpayment on a house.
Melissa believes this decision will greatly improve her financial situation but wanted a second opinion before she signs on the dotted line.
Nick’s assessment & advice
Melissa’s first objective is to get some improvement in her cash flow, which she will then direct to savings. On the surface, it looks like a great improvement to her financial situation, however, it begs the question: what will this cost her?
Understanding weighted average APR
One of the most notable observations about Melissa’s situation is the proportion of her debt that is distributed across high-interest rates and the proportion distributed across low interest. Whilst the credit card and her overdraft are whopping 25 per cent APR and 18 per cent APR respectively, these debts represent only about 4.0 per cent of her total debt.
The other 96 per cent of her total debt is actually below the consolidation loan rate of 13 per cent APR. This means that when the consolidation loan takes up the full load of her debts she may actually be increasing her overall portfolio interest rate called the weighted average interest rate. To find out what her portfolio rate is we need to look at what each debt contributes to the overall portfolio APR (annual percentage rate).
In Table 1 and the chart that follow, we calculated the proportion of each debt in relation to the whole $274,500 debt then multiplied the result by its APR to find out the impact each debt has on the total portfolio APR. As an example, if we take the investment loan balance of $55,000 then divided it by $274,500 we would see this debt makes up 20 per cent of the total debt portfolio.
We then apply this proportion to its APR of 10 per cent (20% x 10% APR = 2%). We then arrive at 2.0 per cent, which is this debt’s contribution to the total portfolio APR of 5.0 per cent. So, then, whilst the consolidation loan improves her cash flow, it is actually costing her more in the long run.
Considering dad’s help
It would be a great idea to have Melissa’s dad as her only creditor because his interest rate is the best at 0 per cent. If she allowed him to clear off all her loans and pay him the same $5,500, it would take 50 months to pay him back. If she decided to pay him the original $8,500 per month, it would only take 32 months.
If Melissa decided to use the fixed deposit of $65,000 to clear off the investment loan and apply the difference of $10,000 to the other loans it would bring her total remaining debt down to $209,500 ($274,500 - $65,000 = $209,500). If dad gave her the extra money, she would now owe him $209,500 but if she paid him $5,500 per month, it would take 38 months to clear him off. If she opted for the $8,500, then it would take just over 24 months to be debt free.
It may seem counterintuitive for her to use the fixed deposit to clear off her debt but if Melissa compares the interest of 0.08 per cent earned against the cost of funds on the existing debt portfolio or the consolidation loan: 5.0 per cent and 13 per cent respectively, she will actually be saving a lot of money with this decision.
Snowball strategy
If Melissa is hell-bent on not borrowing additional money from her dad, she can apply a systematic debt elimination strategy by using the monthly payment from each repaid debt to roll over into the next outstanding debt. The strategy can be fast-tracked by the application of the fixed deposit to clear the investment loan and then using the remaining $10,000 to pay off the credit card and overdraft facilities.
She can now combine the payments from these three debts ($2,500 + $146 + $38 = $2,684) with the car payment of $3,316 totaling $6,000 and clearing this debt in just over seven months ($45,000 / $6,000 = 7.5 months). This payment will now be rolled up with the employer loan payment of $1,500 ($7,500) clearing this debt in less than a year.
At this point, the loan to her dad would have reduced by about $19,000 (7 months + 12 months) and with a payment of $8,500 she will be debt free in a just under eight months. All in all, Melissa can be debt free in about 27 months as compared to six years, saving thousands of dollars in interest.
Nicholas Dean (Cer-Fa) is a financial coach and mentor who is the managing director of the Financial Coaching Centre. He can be contacted at:
Nick.Advice@gmail.com or www.FinancialCoachingCentre.com
