27 Apr Use a Line of Credit to Pay Off Debt AKA: Paying Off Debt with Debt Seems Ridiculous!
Earlier this afternoon, I was reviewing our scenario with Christine. The results seemed just too good to be true. There were a couple of points that she found to be very unusual.
A Line of Credit Works Just Like a Checking Account
First, the idea of using a line of credit the same way we use our checking account feels strange. You just need to make a couple of mental shifts and you’ll see that a line of credit and a checking account are identical. Let’s touch on the key points.
1. To increase the amount of dollars you have in your checking account, you make a deposit. To increase the amount of credit you have in your line of credit, you make a loan payment.
2. In your checking account, you add your deposits and subtract your withdrawals. The remaining amount is your balance. In your line of credit, when you withdraw from your line of credit, this is the amount you owe the bank. When you make a loan payment, this lowers the amount that you owe the bank. The remaining balance is what you owe the bank.
3. If you have an interest bearing checking account, the bank calculates the average for the month. This is called the average daily balance. They use the average daily balance to calculate how much interest they will pay you. Similarly, with a line of credit, the bank calculates the average you owed them for the month. This also is the average daily balance. They use the average daily balance to calculate how much interest you will pay them.
In short, a line of credit works exactly like a checking account. You are adding and subtracting. Each time you make a loan balance, you are subtracting. Each time you withdraw dollars from the line of credit, you are adding the amount that you withdrew to your balance. When you pay more than what you owe the bank, the balance will be in brackets. For example ($10.00) means that the bank owes you $10.00. This is called a credit balance.
Paying Down Debt with Debt Saves You Thousands
Christine shared the concepts she learned from me with a friend. Her friend’s response was, “Using debt to pay off debt is ridiculous!” At first, her response seems correct. Let’s take a closer look.
Which of the following two options would you choose at the end of one month? Earning .2 percent on the money in your checking account and being paid $7.01 or spending just $5 in interest and saving $20,000? I’m pretty sure that you’ll happily pay $5 and save yourself $20,000. You are using the bank’s money to save yourself thousands of dollars.
You’ve turned the tables. Instead of the bank using your money to make loans and create profit for their shareholders, you are using their money to create wealth for yourself.
How did you do it? You used three simple tools: a line of credit, the loan payment and you optimized your average daily balance.
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