subject: How To Get Rid Of Debt Quickly Using Interest Rate Arbitrage [print this page] Numerous financial gurus advocate paying off debt as soon as possible so that you could get to work building a savings. This approach sounds good on the surface, however it isn't always the appropriate financial move. Racking up debt is not difficult when you're young, however learning how to get out of debt quickly is normally a slow and tiring process. Credit cards, student loans, as well as your mortgage make it tricky to build up a sizable savings.
The Debt Snowball
There are many types on the "debt snowball" idea. But, they all have one thing in common. The idea relies on you beginning with one debt, paying off that debt, and applying the freed up capital to the next debt. As you pay off debts, the amount of "free" capital you have raises, rendering it much easier to pay off each following debt. This is the "snowball" effect. It's definitely more of a "savings snowball" than a debt snowball since its your savings that's increasing, not your debt.
For instance, lets say you have these debts:
Credit card - $50/month
Credit card - $100/month
Personal loan - $300/month
Mortgage - $600/month
If you pay off the first credit card, consequently you'll have an extra $50 to apply to the larger credit card. When that credit card is paid off, you can utilize the $50 from the first credit card and the $100 from the second credit card to the personal loan. There's nothing essentially wrong with this approach, however it's not the sole way to get out of debt fast. In fact, it might not even be the most effective.
Arbitrage
Another choice available is to learn how to get out of debt utilizing debt arbitrage. The idea behind debt arbitrage is the fact that you can earn more in your investments compared to what your debt costs you. As long as the money you free up is invested, you can overcome the interest rate you're being charged on the new consolidated loan. Keep in mind, after you've refinanced your debt, you're still paying out the normal monthly payments. If you have combined all of your debts into a new mortgage using a cash-out refinance, for example, then the loan will be paid off according to a set schedule, so don't fret about never paying off those credit cards.
At the same time, you'll be putting that freed up capital to work. In the event that your new consolidated loan have an interest rate of 5 percent, and you are spending your savings at 6 percent, then you'll always earn a lot more than what your debts are costing you. In fact, if you do the math, you can get up to 2 percentage points less than your loan interest rate when your investment is tax-deferred and generating compounded rates of return. The tax-deferral as well as the compounding make up for the fact that you're loan interest rate is higher than your investment interest rate.
When your accumulated savings equals your outstanding debt, you utilize your savings to pay off the debt in full. Simply because your regular monthly payments continue to lower your total unpaid debt with each monthly payment, and you're simultaneously building a savings, you could retire your total debt load quicker than if you had used the "debt snowball". You could even elect to carry the debt for an extended time period, and continue to build your savings Provided that you're earning more on your investments compared to what you're paying in interest, you will always come out ahead.
The sole way to know if this arbitrage strategy will work for you is to contact a financial planner and make a financial plan. Run some figures and see which method of paying off your debt works best for you.
