s p e c i a l s e c t i on: CONST R UCTION TECHNOLOG Y
September 2011
EXECUTIVE
Construction
T H E M A G A Z INE F O R T H E B U SINESS O F CONST R U CTION
also: church upgrades
new people,
new places diversification and client outreach help firms grow
Bottom L ine By Christian D. Malesic
Four Approaches to Paying Down Debt
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| Construction Executive September 2011
the issue becomes determining which one should be paid off first. Four decisionmaking approaches can help firms identify where to start. Interest Rate Approach
In this approach, executives are advised to pay down the debt with the highest interest rate. If the mortgage has an APR of 7.4 percent while the vehicle loan is 6 percent and the credit card is 5.5 percent, choose to funnel debt reduction funds toward the mortgage. This approach is sound and the math is simple. But, it represents only one tool in the financial toolbox to be used when the goal is to reduce total interest paid. Just as a hammer is a wonderful tool, it doesn’t help much when trying to remove a screw or cut a board in half.
Balance Approach
The beauty of debt reduction is the snowball effect, which allows future debt reduction payments to be much larger than initial payments. Once the first debt is paid off, all else being equal, the monthly payment that was previously being paid to that debt is added to the original debt reduction payment, both of which can be applied to the second debt. The balance approach allows the firm to pay down the debt with the smallest balance left on the loan when the goal is to reduce the number of debts owed. If the balance on the mortgage is $258,000, the vehicle loan is $3,500 and the credit card is $8,000, pay off the vehicle loan first. The payment on the vehicle loan is then added to the additional debt reduction payment and applied toward the next debt—either the mortgage or the credit card.
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ebt can be good. It builds credit, allows expansion, closes gaps and funds education. However, too much debt can plague a company. To reduce debt cash flow, a firm first must be able to pay all of the minimum payments on each debt and other monthly expenses. Next, additional debt reduction funds must be available to apply to one of the debts with the intention of eliminating it. Additional funds can be applied in a large lump or in smaller sums over time, but the size of the pot of money is less important than the process. A larger pot will help a company reach debt reduction goals faster and a smaller pot, used correctly, also will take the firm in the proper direction. With multiple debts (e.g., a property mortgage, vehicle loan and credit card),
Bot tom line Cash Flow Approach
This approach aims to reduce the loan that will shrink monthly cash flow; meaning, the amount that is paid each month as the sum of all minimum payments. Mortgages and vehicle loans are often installment loans, so even if a large payment is made above the minimum this month, the same minimum payment is owed next month. On the contrary, credit cards, credit lines and interest-only loans adjust their monthly payment amounts based on the balance due. So, if the minimum monthly payment
on the mortgage is $2,100, the vehicle loan is $650 and the credit card is $200, pay off the credit card first. As the credit card balance is paid down, the minimum payment amount goes down, causing less cash to flow out of the finances. This gives firms the most flexibility in case business takes a turn for the worse, opportunities arise or plans change. Risk Reduction Approach
Like lenders, construction executives should categorize debt based on risk
exposure. Even though the plan may be to eliminate all debt, plans change. In the future, the company may again find itself before a lender, maybe to refinance a loan at a better interest rate, and chances are this will happen before the total debt elimination plan is fully realized. Prepare now by first paying off high-risk debt to reduce overall cumulative risk so lenders are more likely to grant future loans. Lenders categorize debt as secured and unsecured. Secured debt is backed by collateral the lender can repossess or foreclose on should the company cease to keep up its end of the bargain. This can be complicated, as lenders also categorize secured debt based on the value of the collateral, how the collateral normally appreciates or depreciates, and the ability to resell it. For this reason, a well-maintained building is better collateral than undeveloped land, and both are better than a vehicle, which is better than a trencher. The better the collateral, the less risk associated with the debt. Unsecured debt has nothing to back it up except the firm’s word and executive’s signature that it will be paid. Because it is uncollateralized, unsecured debt is the most risky debt. Following the risk reduction approach means paying off the credit card first, followed by the vehicle loan and then the mortgage. The Best Approach
Each approach has merit and can produce a different answer to which debt to reduce first. In the end, construction executives must decide the prudent financial management solution to meet their company’s goals by exploring each approach, analyzing the results, and balancing the findings against corporate strengths and weaknesses while considering possible future scenarios. No decision made to reduce debt is wrong; it will minimize total interest paid, reduce the number of debts owed, add greater flexibility to finances and prepare the firm to seek another loan. Whatever decision is made, make it today. Christian D. Malesic is founder and president/CEO of CM Squared, Inc., Full Service Electricians, Harrisburg, Pa. For more information, visit www.cmsquared.com or follow on Twitter @CDMalesic.
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| Construction Executive September 2011