Debt can be one element of a healthy financial plan. Carrying too much, however, can severely restrict one's ability to take advantage of certain financial opportunities. And the interest that accrues on any loan is money that's not available to be invested for other purposes.
When analyzing your clients' debt levels, you may find that some carry so much that it impedes reaching their goals. If this is the case, consider these strategies to help clients manage and eliminate debt.
Pay Off Debt with the Lowest Balance First
Although conventional wisdom recommends paying down debts with the highest interest rate first, Dave Ramsey, a well-known money coach, recommends that clients start chipping away at the smallest balances first—even if the smaller loans have lower interests rates. The idea is to achieve quick successes early to increase motivation. Another alternative is to transfer the balances of high-interest cards to a lower-interest alternative.
Make Payments on a Pro Rata Basis
For clients who have been successful in reducing discretionary spending to free up cash, spread that money across the total debt. If the pro rata amount for a particular loan happens to be less than the loan's minimum payment, have the client try negotiating with the lender to reduce the minimum for the short term. Otherwise, your client should meet the minimum payment for the lowest interest rate loans and pay more to reduce the total debt on the highest-rate loans. This will allocate more cash to the costliest loans.
Manage Credit Card Debt
Clients struggling with debt may well benefit from a targeted approach to reducing credit card debt—one of the most expensive types of debt. This may include one or more of the following strategies:
- Pay more than the minimum on credit cards. Make sure your client knows that merely paying a credit card's minimum payment won't make much of a dent in any debt. For instance, it would take almost 27 years to pay down a $5,000 balance on a credit card with a 15-percent interest rate and a minimum payment of 2 percent.
- Try an experiment. Often, the idea of changing a behavior can feel overwhelming, but it might feel very doable to try a two-week experiment. If there is something that you think the client needs to change (e.g., buying fewer clothes), offer the idea of a short experiment.
- Leave credit cards at home for a period of time. If credit card debt is a major problem, encourage your client to leave cards at home. This may curb spur-of-the-moment purchases.
- Leave credit cards in the car. If leaving them at home feels too drastic, it can be incredibly helpful to simply leave them in the glove compartment. If the client is open to it, you can recommend an experiment where they choose to leave the credit cards in the car when the go into a store. If they find something they care enough about, they can simply come back out to the car. Forcing that extra step often leads to fewer purchases, as it gives the client a moment to reflect . . . or simply choose not to make the extra effort.
- Delete stored cards on the computer. It’s much harder to make impulse purchases online if you have to go get your wallet and type in your full credit card info. You may recommend that a client refrain from storing his or her credit card info on favorite websites, which again increases the chance that he or she will defer or decline a purchase.
- Compare cards. Clients should understand that the majority of credit cards may charge different rates at different times or for different portions of the card's total balance. This can make it hard to determine the card's average rate and to compare it with other cards. Credit card companies can also use various methods to determine the card's outstanding balance. If the client typically carries over a balance, look for cards that assess finance charges on adjusted balances or single-cycle average daily balances.
- Seek to lower interest rates. Clients should ask their credit card issuers what they can do to lower their card's interest rate. If that doesn't work, consider switching to a new company. Be aware, however, that switching credit card issuers frequently (also known as surfing) can backfire. Some teaser rates apply only to transfers but not to new purchases.
- Be aware of hidden fees. Although the interest rate generates the bulk of the cost of using a credit card, some cards may have a low rate but make up the difference in other fees. Even card offers that waive the annual fee may have the option to start charging one in the second year. Reward cards—such as those that offer frequent flyer miles or cash back for purchases—generally come with higher interest rates. These cards are best for borrowers who pay the entire balance each month.
Manage Credit Ratings
It's no secret that the lowest-cost loans are generally offered only to borrowers with the best credit ratings. Although a person's credit score is composed of multiple factors, the most important are:
- Payment history
- Current level of debt
Online banking and bill-pay services make it easy to pay bills on time. And bringing down card balances can help improve the ratio of debt to credit, thus improving a credit score.
Create a Financial Plan
Don't assume that your clients understand the time value of money or the impact of variable returns on a savings plan. A written financial plan can illustrate how a disciplined approach to saving and debt management can help clients pursue financial goals. It is also important that clients understand what can create roadblocks for even the best plan.
Be sure to include a review of the most important asset—the ability to earn an income. Evaluate whether or not the loss of the income would endanger the ability to manage debt and, if so, put life and disability insurance at the top of this list of must-have financial resources.
Make Saving Automatic
You have probably already discovered that even clients with healthy incomes and resources can make poor choices. To help clients avoid financial pitfalls, systematize their financial lives as much as possible. For example, have clients arrange for their employers to transfer automatic salary reductions to a bank savings or money market account or, ideally, directly into an investment account. Whenever possible, make sure clients set up automatic bill payment from bank checking accounts. Use a program like Mint to help with budget tracking.
When the Problem Is Too Big, Seek Outside Help
At some point, you may encounter a client who has more debt than he or she can afford. Because of the psychological and relationship issues that accompany this problem, it may be more than you can handle. In such a case, consider referring him or her to a nonprofit consumer credit counseling agency, a couple's therapist who specializes in money issues, or—if he or she is considering filing for bankruptcy—a qualified bankruptcy attorney.
Do you frequently help clients manage and eliminate debt? Are there other strategies for financial advisors to help clients in debt? Share your best practices by commenting below.