Live Debt-Free

That throbbing in your head? That's a hangover from the borrowing binge we've enjoyed for most of this young century. And make no mistake, we did enjoy it. We bought record numbers of homes and filled their three-car garages with shiny vehicles boasting DVD players and heated seats. We regaled our friends and neighbors with the details of our cash-out refinancing — and the ski trip to Aspen it paid for. The beauty of the whole shindig was that we could justify it financially, since the costs of borrowing were relatively low. We were like mini private-equity firms, using cheap debt as leverage to scoop up our share of the American Dream.

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In retrospect, it's clear that what started as a celebration morphed into quite a bender. According to the Commerce Department, Americans collectively spent more than we earned after taxes for the past two years in a row — the first time that's happened since the Great Depression. The household debt-to-income ratio has reached an all-time high, topping 19%. Meanwhile, many forecasters see rising inflation and interest rates ahead. Michael Hudson, president for the Institute for the Study of Long-term Economic Trends, sums things up pretty simply: "The free lunch is over."

That means that for many of us it's time for two aspirin, a splash of cold water and a new attitude toward personal finance. The new motto: The less debt you have, the happier — and wealthier — you'll be. And while even the caviar and Cristal crowd seldom live their whole lives without borrowing, keeping your debt load as light and as cheap as possible is the key to a more secure future and to guilt-free spending on the things you need and want.

It's a skill that's often neglected and seldom discussed, but understanding how to manage your debt will let you build wealth faster, and with less risk. Disciplined saving and smart investing are the topics that get the most ink — hey, we read this magazine too — but without a good debt strategy, the planning for your financial future can get awfully wobbly. The explanation comes down to Home Economics 101: Paying interest works against you in the same way that earning it works for you when you invest. The average household owes about $9,900 on credit cards at an annual rate of 15%, according to the research firm CardTrak.com, costing about $1,500 a year in interest. If a family invested that interest every year instead and earned 8%, after 30 years they would have an extra $181,700. With auto, college and even mortgage loans, the interest snowball is a little smaller because rates are lower, but you'd still much rather throw it than get hit by it.

If becoming debt-free can seem like a pipe dream, it's one that most of us share: A recent survey by the financial-services company LendingTree shows that 74% of Americans envision themselves debt-free, excluding mortgages, at some point in their lives, but only half said they have a plan for how to get there. Luckily, SmartMoney has one too — which focuses on carrying only as much debt as you need, keeping it cheap by snagging the lowest interest rates and getting to debt freedom sooner rather than later. We've even got a finish line for our plan: retirement. After all, once a person starts living off a nest egg rather than a salary, those interest payments hurt all that much more, forcing the retiree to live on less to stretch the savings. "The people who have the most trouble are the people who carry the most debt into their retirement years," says Charles Farrell, a financial adviser in Denver. "Those fixed obligations can bury you."

To be sure, some debt — especially a mortgage, for which the interest is usually tax-deductible — is a prudent fit in one's financial life, especially for younger people. But as any good thesaurus will tell you, debt is just another word for liability. In trying to cope with it, many people wind up foundering because they try to employ separate strategies for each of their burdens, attacking their credit cards, auto loans and other obligations as if they were unrelated enemies.

We think there's a better way to move toward a debt-free life: adopting approaches that can generally be applied to all debt. It means, for example, speeding up payments on just about every category of debt, from mortgages to school loans, and shifting to as many "fixed" loans as possible. Below, we'll outline strategies that can be used, together or in tandem, to tackle all kinds of obligations — in ways that can save hundreds of thousands of dollars over a lifetime.

Change the Monthly Mind-Set

Let's say the Tooth Fairy makes a rounding error at your house this month, and you find yourself with a little extra cash in hand. Sure, the approaching football season cries out for high-def television, and Tuscany is gorgeous in the fall. But for anyone shouldering a big debt load, the wisest move may be to plow that windfall right into a jumbo payment on your car, your Visa or even your house. In an era when most big purchases are handled through comfortable monthly installments, that advice seems downright counterintuitive. But let's be blunt: "Affordable monthly payment" is banker-speak for "we're making a killing on this loan." If you think of debt management as more like conventional shopping — an opportunity to get the best product for the lowest total price — then the smaller your monthly payments, the weaker your strategy. And if you're doing fiscal backflips to make those payments smaller, says Kenneth Kamen, a wealth-management consultant in Princeton, N.J., "that is life telling you your eyes are bigger than your wallet."

So if you're in the habit of making relatively small payments, stretching beyond your comfort zone could pay off big down the road. First priority is to knock out all credit cards, starting with those with the highest interest rates. Say you're carrying that average American balance of around $9,900 on a card with a 15% interest rate. If you pay $250 per month, slightly more than the minimum payment, it'll take 55 months to pay off the card; by upping the payment to $1,000, you can pay it off in less than a year — and save yourself more than $3,100 in interest. The same strategies can come in handy for home-equity loans, but be sure to check with your lender about potential prepayment fees.

The "low monthly" mind-set can take an even higher toll when it comes to your auto loan. In the not too distant past, the typical car loan lasted three years. Today the average duration is almost five and a half years, according to the car-research web site Edmunds.com, and seven- and eight-year loans aren't uncommon. Drivers buckle themselves into these deals in search of lower payments, but they're headed for a long-term financial collision. Let's say you have your eyes on a $45,000 Land Rover. You put $5,000 down and finance the other $40,000 at 7%. If you spread that loan over three years, you'll pay $1,235 a month, and $4,463 in interest by the time you own the car free and clear. Spread it over seven years and your monthly payments will drop by half — but you'll pay a hefty $10,711 in interest before the car is really yours. And all the while, of course, that Rover is depreciating, making your long-term borrowing look even sillier. By year five of the loan, there's a good chance you'll owe more than the car is worth — what dealers call being "upside down." The good news: If you're in a loan like this, it's a great target for extra payments because most car loans don't charge prepayment penalties.

The bigger-payment approach gets more complicated when it comes to your biggest-ticket debt item: the mortgage. Mortgage debt almost always carries lower rates than other types of debt, and the interest is tax-deductible — if you have a 6% mortgage and occupy the 28% tax bracket, you effectively knock another percentage point or two off the cost of that loan. Jimi Ellis, a San Antonio real estate developer, recently considered paying off his home outright with the windfall from a business deal, but crunched the numbers and found he's better off sticking with a mortgage — he figures the interest deduction will save him close to $4,000 a year in taxes.

Still, some borrowers may see some advantage in wiping the liability column clean sooner. If you start the process early on in your home-owning years, you can cut the overall cost of the home and free up some serious money for the savings account. But making only occasional extra payments is "like trying to move a mountain with a teaspoon," says Keith Gumbinger, a vice president with mortgage research firm HSH Associates. A better approach is to make it a regular affair: You could increase the size of each monthly payment by one-twelfth, for example, making the equivalent of one extra monthly payment each year. It doesn't seem like much, but if you start early, you can shave seven years off the life of a 30-year mortgage — and, on a $400,000 loan, trim about $100,000 from the total cost. Paying off early could also benefit you once retirement comes: Your nest egg won't have to cover a home payment, and since you'll have 100% equity, you'll have an even bigger pool of assets to draw from should you ever decide on a reverse mortgage.

Fix It and Forget It

David and Yvonne Hernandez knew it would be a stretch to afford the four-bedroom house in Hayward, in the East Bay outside of San Francisco. But it was two doors down from Yvonne's parents, an important factor for their tight-knit family. So in 2003 they bought it by taking on an interest-only adjustable-rate mortgage (or ARM) for slightly more than $400,000. The interest rate opened at a reasonable 5.8%, but then crept higher by about a point per year. By last year, they were paying an extra $300 per month as the rate reached 8.9%. "It started to freak me out," Yvonne says. Alarmed, the couple started shopping for a fixed-rate mortgage — something to eliminate future surprises.

By now, housing-bubble headlines have made mortgage ARM-twisting all too familiar. While a fixed-rate mortgage provides for a steady interest rate throughout the duration of the loan, an ARM offers a lower initial rate, but allows for future interest to float with prevailing market rates. At the peak of their popularity in 2004, about 33% of all new mortgages were ARMs. Today it's closer to 20% and dropping, but this year about $400 billion in adjustable-rate mortgages are scheduled to reset for the first time, with another $1 trillion due next year.

Despite the bad press, ARMs are not always bad deals: Because they float with short-term interest rates, they can provide a way for homeowners to capitalize on falling rates without refinancing. But they also can turn costly when rates rise, as they have lately. And for borrowers like the Hernandez family who opted for an "exotic" or "exploding" ARM, trouble can mount even more quickly. These loans typically have too-good-to-be-true initial rates that result in too-high-to-stomach payments after the short teaser period. The increases are capped — two percentage points annually and five or six total over the life of the loan are common terms — but many borrowers didn't understand the dramatic impact those bumps can have. "I think they should be called 'scary' or 'totally unpredictable' or 'impossible to understand,'" says Kirsten Keefe, executive director of Americans for Fairness in Lending. For many who either bought too much house or gambled that they could profitably flip the property, the outlook could be bleak. According to a recent study by First American CoreLogic, 32% of those who started with low teaser rates will eventually face foreclosure.

Fortunately, interest rates remain relatively low for now, giving those with good credit and income a chance to get into a saner fixed-rate loan. The rate will likely fall somewhere between an ARM's teaser rate and its post-reset rate, but with no uncertainty about future market conditions. "You can always refinance if rates fall down the road," points out Gary Houle, a financial planner in Houston who, like most in his profession, vastly prefers to steer people toward fixed rates.

Many lenders will make you cough up some dough to refinance. On an ARM, the most common penalty is 1% of the loan value if it's paid back in its early years, usually the first five or so. Do the math to make sure that fee will pay for itself in lower monthly payments down the road; if you don't plan to stay in the home long, it may not be worth refinancing. But for the Hernandez family, it was. Well-armed with good credit and household income totaling more than $100,000, they were able to land a 30-year fixed-rate mortgage at 5.75%. On top of that, they added a second mortgage at 7.25% that allowed them to consolidate credit card debt they had incurred putting on a new roof and adding landscaping. All told, they will save more than $17,000 per year in interest charges alone, and deep into six figures over the life of the mortgage. "This is working out perfect," says Yvonne.

Mortgages aren't the only field where fixed rates offer big advantages. Home-equity loans are virtually always fixed — more on those later. And while their issuers don't necessarily trumpet them, there are fixed-rate credit cards on the market. It takes a good credit score to get one, but in recent years their rates have typically been two to three percentage points below variable-rate cards. To find fixed-rate offers, check card-comparison sites like CardRatings.com.

Shuffle the Cards

They fill your mailbox and, later, your paper shredder, and they make you think there must be a catch, somewhere. They're zero-interest balance-transfer offers from credit card companies. An environmental blight on the planet, perhaps, but also a tool that a savvy household can use to drastically slash the cost of its debt. When Scott and Elizabeth Blankenship of Houston realized that they were paying what Elizabeth calls a "ridiculous" 17% on their $3,100 card balance, they went straight to another issuer — their primary bank, Bank of America — and asked for a zero-interest card. The rate on their new plastic will reset to 9% after 15 months, but by then the thirtysomething couple plans to have paid off the debt entirely. In the meantime, they'll save about $750 in interest charges and apply that money to Elizabeth's college loans. "It's not huge, but every little bit matters," says Elizabeth.

When credit card companies make the zero-interest pitch, they're making a calculated two-pronged gamble: First, that you won't pay off the transfer before the rate resets, and second, that you'll use the card to run up a new, interest-bearing balance. Admittedly, zero-interest offers are not as generous as they were at the beginning of this decade, when interest rates were scraping the floor. Three or four years ago, companies routinely offered 18- and 24-month interest-free repayment periods, but today the norm is a year, while some offer as little as six months. No-fee transfers have also dwindled, and the fees themselves have gotten higher, says Curtis Arnold, editor of CardRatings.com. Where many issuers once capped transfer fees at $50 or $75 per transaction, it's now typically 3%, adding $300 to a $10,000 transfer. But the deals can still help you cut the costs of a lingering balance. And for those unsure that they can pay the balance before the rate resets, there are cards that don't have a deadline. The tradeoff is that you'll pay some interest, but it's usually rather modest compared with the typical 14% or 15%. The American Express Blue card, for example, carries a 5% rate for the life of the transfer.

Because of the various fees, you'll be happier if you can keep your card interest low to begin with. Arnold estimates that fewer than 10% of active cards have rates below 10%. But to qualify for a rate in that lower range you typically need, at minimum, a credit score of 700 — only a shade higher than the national average, which is 692, according to the credit-tracking firm Experian. The implication: A lot of us could be getting lower rates if we only got around to asking for them. After all, Arnold notes, it costs credit card issuers between $200 and $300 to acquire each new customer, and while that may not seem like much, they'd still prefer not to lose you. And the process is almost embarrassingly easy. Simply call the customer-service line and say that you believe you are entitled to a better rate. (Ask for a supervisor if necessary.) It helps if you know your credit score and can cite it proudly when calling. "If your credit is good and you've been a good customer, you are in the driver's seat," Arnold says.

Cheap credit card rates can really snowball in your favor: You'll be able to pay down debt faster, raising your credit score and prompting companies to fight to get you as a customer — and making them more likely to give you zero-interest offers. Once you're in this position, you can get creative with financing bigger purchases. Robert Greene, a financial planner in Sherman Oaks, Calif., recently fell for a sleek 2003 Mercedes E500 sedan — until he found out the dealer wanted to charge him close to 10% to finance it. Instead, Greene rotated the debt to a card with a transfer rate of just 1% for nine months. If, as planned, he pays it off before the card resets, the $30,000-plus "loan" Greene took from his credit card company will cost him only $200 in interest. If he doesn't pay it off, he says he'll simply transfer the balance to another low-interest card.

All Under One Roof

Borrowing money at low interest to pay off high-interest debts is one of the no-brainer rules of money management — right up there with "buy low, sell high." And for any family juggling student loans and credit cards along with home and auto financing, it's got another benefit: With fewer payments to keep track of, you're less likely to accidentally miss one and make your interest rate soar.

So the big question isn't whether to consolidate, it's where. The most available source of cheap credit these days is home equity. Granted, as a nation we're already pretty loaded up: Between 2001 and 2005, homeowners cashed out an average of $365 billion a year in home equity, almost five times more than the average during the previous decade, according to a recent report by former Fed Chairman Alan Greenspan and Fed economist James Kennedy. Bank of America, the nation's largest home-equity lender, says that about 20% of its home-equity borrowers use that money to pay down debt. Still, home equity remains an attractive source of money because in many cases the interest on the loans is tax-deductible. Add that advantage to rates that are lower than most credit cards' and many privately issued student loans', and "the savings can be substantial," says Peggy Lawlor, Bank of America's home-equity lending executive.

With seemingly a zillion products out there that tap home equity, what's the best way? In most cases, we recommend a straightforward home-equity loan. In recent years home-equity lines of credit have been more popular, but they usually fluctuate with short-term interest rates, while straight-up home-equity loans are fixed. Rates on HELOCs now average almost 9%, up from 4.6% in early 2004, while home-equity loans average about 8%. Loans also offer a bit of built-in discipline: With a loan, you're borrowing a specific amount, while a HELOC gives you a checkbook attached to a pool of credit that may be overly tempting the next time you get inspired watching This Old House.

Why not just pay off your bills with a cash-out refinancing and grab an even lower rate? The key factor here is the repayment period. By refinancing $20,000 in credit card debt with a 10-year, 8.12% home-equity loan, for example, you pay a little more than $9,000 in interest payments. If instead you went with a cash-out refinancing in which you included the credit card debt in a whole new mortgage, you'd essentially pay about $50,000 in interest over 30 years on that original $20,000, and you'd pay hefty closing costs, too.

Home-equity financing also has some appeal for anyone saddled with debt from years of book learnin' — their own, or their kids'. Government-backed college loans, such as Stafford and Perkins loans, often have competitive rates that make rolling them over less worthwhile. But consolidation can offer much more relief to the growing number of borrowers who have had to turn to the private market for loans as college costs have soared. These loans, which now account for 20% of the $85 billion issued each year, carry variable rates that can drift into the double digits and rival those of credit cards. It's possible to consolidate private loans at a lower rate if you've improved your credit score since you first borrowed them, and some lenders offer deals that let you "buy down" your interest rate with an upfront cash payment. But at present, with the private-loan industry under investigation and facing a possible overhaul, there's enough uncertainty in the market to unsettle even those who spent their money on an economics degree. A home-equity loan won't make school debt go away overnight, but it could free up some cash for a campus visit on game day.