A debt management plan (DMP) is an informal arrangement between a person who has debts he cannot afford to repay, and his unsecured creditor. Its main purpose is to guarantee that a percentage of the amount owed by the debtor is repaid, rather than none at all. DMP is both beneficial for both parties. The debtor avoids a possible bankruptcy and the resulting big negative impact on his credit score, and the creditors gain more money than they would if the debtor suffers bankruptcy. Nevertheless, even with a DMP you will still suffer some negative impact to your credit score, but this will be less and for a shorter period of time than with a bankruptcy.
An effective DMP is the way to financial success. With good debt management strategies, you can save money on interest expenses and improve your odds for securing a positive credit score in the future. As part of the financial management, a debtor should differentiate bad and good debt. With this knowledge, he can best make strategic debt payments.
Good Debt vs. Bad Debt
Good debt is leveraged to purchase services, goods, and assets that generate additional money. Furthermore, good debt usually features low, tax-deductible interest rates. Examples of good debt include a mortgage alongside business and student loans. On the other hand, bad debt is associated with consumer expenditure that doesn’t add value to your bottom line. For instance, you may put fine restaurant, vacation packages, and designer jeans expenses on your credit card. High interest rates on your credit card would further add to the costs of these items or services. Through debt management planning, your main objective would always be to minimize your bad debt.
You should request a copy of your credit report so that you can organize debt balances according type, size, and payment history. Also, you should check your credit report on a regular basis to identify errors, which may be a sign of fraud or identity theft. Any false information stated on your credit report will subject you to unreasonably high rejection and interest rates.
You may request one free credit report per year. At any time, you can also purchase your credit score and report from various debt management companies and agencies that offer credit reporting and marketing services. These agencies do provide online resources that guide you how to dispute incorrect or fraudulent information on your credit report.
After you receive the credit report, you need to contact all of your creditors and try to negotiate lower interest rate. To keep your business, a creditor will be more likely to offer you lower interest rate if you have demonstrated a good or proven track record of paying the money back on time. If your current creditor is not willing to offer a lower interest rate, you can refinance by taking on new loan and using the proceeds to repay the old loan.
The goal of refinancing is to effectively reduce the interest rates of your debt. For big loans, such as a mortgage loan, refinancing will start closing costs that are typically three percent of your loan principal. As a general rule, you should refinance a mortgage loan when you can reduce the interest rate by more than 1% and plan upon owning the associate property for at least the next 10 years.
Analyze Your Sources of Income
As part of your DMP, you should analyze your current finances to find sources of money that can be used to make payments. To generate money, you should sell off your under-performing investments in which the returns don’t exceed your interest charges. For instance, you should liquidate a £10,000 bond portfolio that generates 5% returns annually, if you also have £10,000 worth of credit card debt at 20% interest rates.
When it comes to cash reserves, funds above 6 months worth of living expenditures can be withdrawn to repay debts. For affordability, you can spend 36% of your gross income on debt payments regularly.
You should prioritize making strategic payments for your debts according to interest rates. This can be done by making minimum payments on all your debt balances—to keep cash for your most expensive balance. Once your most expensive debt is fully paid, you can then turn your focus to the balance with the next highest interest charges.