Guest Post

Trying to get out of debt can be a difficult task. Due to interest, it seems as though debt keeps on growing. It can be hard to pay off your debt — especially if you only make minimum payments. In order to make headway, it is vital that you start to making more than the minimum payment on the debt. Here are some ways that you can find room in your budget to help reduce your debt:

Identify — and Cut — the Financial Waste in Your Monthly Budget

The first thing to do is figure out where you can cut back on your spending. There are some estimates that each household wastes up to 15% of its income each month. Think about that. If you make $4,000 a month, that means that you could be wasting up to $600 each month. Consider how much headway you could make with your debt if you applied even half that on top of a minimum payment.

Go through your spending and see where your money leaks are. Look for ways to plug them, and then use the money you save to set up a debt paydown plan. One of the most effective ways to reduce debt is to use a version of the debt snowball, paying off one debt at a time so that your efforts are more concentrated — and more efficient.

Increase Your Income

Another strategy you can use to pay off your debt is to increase your income. Look for ways to make a little more money. If you honestly feel that you have no waste in your monthly budget, or if you don’t think you can make the necessary cuts, you can choose to increase your income and put that money toward paying down your debt. Some of the things you can do to increase your income include:

• Get a part-time job: You can look for part-time job that can be done on evenings or weekends.

• Start a side-hustle: If you don’t like the job options available to you, you can start your own business. Get a side hustle working out of your home. From providing services like pet walking or tutoring, to doing odd jobs and landscaping, you can look for ways to make more.

• Cultivate passive income: You can also cultivate passive income by monetizing a web site, putting together a creative work, or looking into income investments like dividend stocks. However, it can take time to cultivate these types of income streams, so it may not be the best option if you want to pay down your debt quickly.

Putting extra income toward debt paydown can help speed up the process, and result in you saving more money in interest. If you are experiencing debt problems you can consider some form of debt consolidation that may result in lower interest charges.

Combining the Two: Debt Paydown in High Gear

If you really want to kick your debt paydown into high gear, you can combine the two strategies. If you can cut your expenses, while increasing your income, you can make even more headway with your debt. Remember that it is only for a limited time, and that your hard work will pay off quicker. The bottom line is that you really need a plan if you want to pay off your debt. The greater your effort, the more you will save, and the sooner you will find financial freedom.

Janet writes for Credit, Eh, a blog about responsible credit card use and personal finance.

It’s easier when you take care of a few things first

By Kevin M

It’s been said that the best way to accomplish a big project is to break it into a series of smaller ones. Paying off credit cards can be as big a project as we can imagine, based on the size of the debt that needs to be paid off.

Often it’s the size of the debt itself that presents the biggest obstacle to even getting started. While it may not be too difficult to payoff $10,000 in credit card debt going from a standing start, a balance of $50,000 will require marshalling all of our efforts and resources.

It’s important to realize that paying off credit cards isn’t just about discipline. A huge part of the project is emotional and you’ll have to do it in such a way that you’re rewarding your efforts by reaching crucial milestones along the way. Take it in stages, stack the deck in your favor, and the whole process will be less painful.

Implement a plan to cut living expenses

It’ll be impossible to payoff your credit card debt—or accomplish nearly any other financial goal—without developing and implementing a plan to cut your living expenses. How far you need to go to do this depends on the amount of debt that needs to be paid off.

If your debt is just a few thousand dollars, this might be accomplished by cutting at the fringes. By eliminating eating out, some forms of entertainment or cutting a service, like cable TV, you might find the necessary room in your budget to take down your debt in short order.

But if the debt is well into five figures–$20,000, $30,000, $50,000—some serious self denial will be in order. A debt of this size may require cutting not just fat out of your budget, but meat. That could even extend to modifying your living arrangement by moving to less expensive quarters or taking in an additional resident for a fee.

Alternatively, you can also concentrate on increasing your income through a second job or side business. This can be a tough balancing act, but always remind yourself that it’s a) for a good cause, and b) it’s only temporary!

However you decide to approach your plan, there won’t be any plan at all unless you can find the extra income to carry it out.

Build up a cash cushion

Once you find the proper mix of spending cuts or additional income, Step 2 is to build a cash cushion, that way you’ll have funds to fall back on in an emergency without having to tap your credit cards.

This point is fundamental. In order to get rid of your credit cards you must first eliminate your dependence on them. The only way to do this effectively and permanently is to become “self-financing”. Once you have extra cash flow in your budget and a generous savings account you will be self-financing and no longer in need of credit cards.

How large should the savings account be? Personally, I think three months living expenses is a good minimum. With a balance that size, you’ll have enough to cover reasonable emergencies and—even more important—as tangible evidence to yourself of your ability to live beneath your means. Once you reach this level you’re at least halfway home!

I favor rapid cash accumulation, and there are several ways to do this, even if you’ve never been a saver in the past. Make minimum credit card payments while you cut expenses, find extra income or even sell your stuff to raise cash. The quicker you’re able to do this, the easier it will be for you to believe that you will also be able to pay off your credit cards.

Payoff short term installment loans

There’s one more step before we start hitting the credit cards: installment loans with small balances.

Do you have a car loan with ten months to pay on it? Or a loan on a suite of furniture for a thousand or two? Get rid of them.

Here’s why:

1. Short term installment loans have high payment-to-balance ratios, which is taxing to your cash flow. The sooner you get rid of them, the more money you’ll have to throw at your credit cards.
2. Installment loans are typically attached to your possessions, which means that should you fall on hard times, the creditor can seize them. How sad would it be to lose an $8000 car because of a $2000 car loan that only had eight payments remaining?
3. Debt is debt, and it all needs to go. For the above reasons, start with short term installment loans.

Even if you have lower interest rates on your installment loans than on your credit cards, pay them off anyway. This isn’t about interest rates; it’s about paying off the debts that cause the interest rates. We need to think strategically, which is to say we need to re-arrange our financial situations in ways that will bring about permanent improvement in our overall financial conditions.

Then tackle the credit cards!

With breathing room in your budget, money in the bank and the elimination of small installment loans (providing yet more breathing room in your budget) you’re finally ready to take on those annoying credit cards. And yes, I said “annoying” because with all of the above taken care of, your credit cards will be more of a nuisance than an actual problem. You’ll be attacking them from a position of strength which you have already attained and don’t need to wait to feel and enjoy until your plastic is paid. You’ve given yourself the upper hand.

Like Dave Ramsey and so many personal finance blogs advocate, I believe paying off the cards with the smallest balances first to be the most effective course. It’s the divide-and-conquer strategy where you pick off the small weak ones first. Those will be the quickest to go, and as each one does your sense of accomplishment will grow, as will the funds to take on the next card.

Once you’ve paid off the little ones, the bigger ones will seem much less daunting and you can throw everything you have at them until their gone. And you’re free.

 
Paying off credit cards isn’t just about getting rid a certain type of debt. At the core, it’s the pursuit of financial independence itself. When you owe no one, then no one owns you!

Even if we can’t be wealthy, being free from debt removes financial bondage, and frees up our time, resources and attitude to take on new careers or business ventures, to relocate if and when necessary, or just to live the lives we choose.

Have you paid off a large credit card balance? If so, what can you share about the best ways to do it?

Repair Bad Credit to Make Your Financial Future Better

( Photo courtesy of Andres Rueda )

By Kevin M

Two of the most important components of retirement planning are a generous retirement savings plan and a mortgage free home. But if limited resources force you to make a choice, which goal should get the lion’s share of your extra income?

There are three basic choices:

1) Emphasize retirement and let the mortgage slowly amortize itself into extinction
2) Throw all extra funds at the mortgage, and once it’s paid you’ll have even more money to put into retirement
3) A hybrid plan where you try to do both at the same time

This isn’t a good solution-bad solution debate. There are plusses and minuses no matter which way you go, and fortunately all three can get us where we need to go. Which one we choose will depend largely on individual circumstances and preferences.

Retirement savings first, mortgage later

Advantages: By building retirement savings early, we’re not only maximizing the time value of money but we’re getting the advantage of tax deferral in the process. The bigger the pile accumulated early, the less we’ll need to commit as we get closer to retirement—the hard work will already be done.

Disadvantages: Much of the advantage of frontloading retirement depends on the performance of the stock market. If the market doesn’t turn in decidedly positive returns, the whole scenario weakens considerably. Stocks also carry a substantial risk of loss; paying off a mortgage, by contrast, has none of that risk.

Mortgage payoff first, retirement savings later

Advantages: The biggest impact of prepaying a mortgage takes place in the first few years. This is because mortgage payments are overwhelmingly comprised of interest in the first few years. The sooner you can pay down the balance, the sooner the interest/principal divide begins to work in your favor. By making prepayments early, the term of the loan will be reduced. You can cut your term in half by making substantial prepayments in the first few years. Once your mortgage is paid, your cash flow will improve enabling you to save money at a higher rate than ever before.

Paying down a mortgage effectively locks in a rate of return equivalent to the interest rate on your loan. A guaranteed 5-6% return on mortgage payoff will look really good the next time the stock market hits the skids. This is no small advantage given that the stock market has experienced two major slides in just the past 10 years.

Disadvantages: When funds are committed to mortgage prepayment, there are only two ways to get it out in an emergency: borrow it out or sell the property. The first defeats the purpose of prepaying, and the second is disruptive and difficult to pull off, especially in a weak housing market.

As you pay down your loan balance, the mortgage interest tax benefit will decline. Also while prepayments will shorten the term of the loan, your payment will remain the same until the loan is fully paid.

The Hybrid Solution—juggling both at the same time

Advantages: By taking on both projects simultaneously, you make steady, if slower, progress on two important goals at the same time. You also keep your options open to favor one over the other at some point in the future when it may become advantageous to do so. For example, another crash in the stock market may create a one time buying opportunity when you’ll want to shift excess funds to retirement savings to do some bottom fishing. Alternatively, once your mortgage balance falls to a certain level, you may want to concentrate funds there if you might be able to pay it completely in three of four years.

Disadvantages: You’re pouring money into two long term projects at once, limiting the impact on both while quite possibly draining your budget for two plans that offer no immediate benefit. There’s a compelling school of thought that we’re most effective when we throw all of our effort behind a single worthy goal.

My personal opinion

Everyone’s situation is different and there are no hard and fast rules, but since I generally favor savings ahead of debt payoff, I think that for the typical homeowner it’s best to emphasize building up retirement savings over mortgage payoff. This is especially true if you’re early in either situation.

Time is an important factor with retirement savings; the biggest advantage comes when you’re able to plow a lot of money in early. Delaying or minimizing contributions in the early years will have serious opportunity costs.

Mortgages are what we might call patient debt. A 30- or 15-year fixed rate mortgage isn’t going anywhere. The payments are fixed for the term of the loan and the rate will never increase. They’re also self-amortizing, so even if we do nothing more than make the scheduled payments, the principal balance will go down, albeit slowly. Unlike credit cards and some other forms of debt, we can afford to leave mortgages alone until we’re ready to deal with them.

It might be better to focus on maximizing retirement savings early on, then shift resources into mortgage prepayment later. If you reach a point where your retirement savings are larger than your mortgage, the effort will seem that much easier.

Two exceptions…

There are however two exceptions on this opinion: 1) if you have minimal equity in your home or 2) if your mortgage is of the exotic variety.

If you purchased your home with a minimum down payment—or even more if it was with 100% financing—and your equity position has gone negative, this is a situation that demands immediate cash infusion until the equity deficiency is cured.

The same is true of exotic mortgages—adjustable rate loans, balloons, interest only and anything of the sub-prime variety. In the current real estate market, a refinance could be complicated if the value of your home has fallen significantly. Rebuilding equity is critical.

Adjustable rate mortgages depend on low rates. Don’t allow the calm rate environment of the past few years to lull you into thinking that low rates are forever. Balloon loans could cause a need to refinance, and equity could be a problem. On interest-only mortgages the only way to reduce the balance will be to make direct principal reductions. And sub-prime loans just need to go away, period.

Any of these mortgage types, along with a weak equity position, might have you in a crisis where the loan represents a near term threat to either your financial position or to your household stability. The mortgage should necessarily be the priority to receive any excess funds.

Still another option of course is to lower the rate and payment on your mortgage (or to purchase a different home) but in today’s tougher lending environment, first find out how to pre qualify for mortgage.

But apart from these two exceptions, I think the emphasis should be on retirement savings first.

Which camp are you in, retirement savings first, payoff the mortgage first or taking on both at the same time?

By Kevin M

Despite the near sacrosanct status of tax sheltered retirement accounts, there are situations in which liquidation makes abundant sense. From the outset, let me say that I don’t advocate raiding retirement accounts except under extreme circumstances.

When to consider tapping retirement savings

My personal opinion is that if survival is at stake tapping retirement savings MUST be on the table. Under certain circumstances it becomes beyond absurd to allow your financial situation to collapse while protecting retirement savings. Retirement savings are, after all, a financial tool and not some sort of gold-plated legacy to be shielded at all costs.

Under what circumstances should we seriously consider withdrawal?

1. When debt payments are so high that they threaten your ability to pay necessary expenses such as food and utilities
2. When debt payments are so high that you’re loosing sleep; stress causes lost productivity and wears down our health, and we need both if we even hope to make it to retirement age
3. When we’ve exhausted all other assets in a financial crisis
4. When we’re flirting with disaster by having substantial debt and no liquid savings
5. When we’re paying substantially more in interest on debt than we’re earning on our retirement assets (more on this point in the next section)

Even under any of these circumstances, we should consider other options before going the retirement liquidation route. Get a second job, cut expenses to the bone, liquidate non-retirement assets, sell personal possessions, and even consider selling your house or a second car. Drastic situations require drastic measures.

But let’s say you’re already doing some or all of those things, but you still can’t get out from under, what do you do? You do what ever you need to do. Remember, conventional wisdom is based on general circumstances; you’re personal situation might not fit neatly in that category.

High credit card debt is an effective margin loan

Items 1-4 above are largely self-explanatory, but I want to camp out on #5.

Having large credit card balances relative to retirement assets is the one situation in which I feel withdrawal or liquidation may be justified even though personal financial survival may not hang in the balance in any immediate sense. Here’s why…

If you have large credit card debt it represents an effective margin loan against the savings plan. True, there may be no legal connection between the two, but the financial connection is quite real.

Let’s be clear that what I’m referring to here is not periodic episodes of tapping retirement savings to clean up credit card balances. That’s plain poor financial management that needs to be addressed at a more basic level. What I’m referring to is when we might be carrying an unwieldy level of credit card debt which might be in need of a one time adjustment—a sort of self-imposed bankruptcy liquidation—so that we can truly move forward in improving the total financial picture.

Let’s do this by considering an example. If we have $30,000 in retirement savings and $25,000 in credit card debt, we’re not really worth $30,000. Our net worth—the value of our retirement savings, less the value of our credit card debt—is only $5,000. What ever thoughts we might harbor about our finances, this is the reality.

Ultimately, our finances aren’t a collection of mutually exclusive components, but a unified whole—and that’s how we need to approach it.

Using the numbers above, what are the relevant facts to consider in carrying high credit card debt while protecting retirement savings?

The situation is financially unsustainable. Let’s say we decide not to take any risks with our retirement savings, and invest the entire account in fixed rate savings vehicles of varying maturities paying an average return of 3%; if we’re paying an average of 13% on our credit card balances, that means we’re losing 10% in the exchange every year that we allow this situation to continue!

We might close the gap by investing in higher yield, higher risk vehicles, but when we do that we’re now matching uncertain returns against the guaranteed interest expense on credit card debt. The situation is completely unbalanced and will gradually, quietly and needlessly drain our resources.

Paying off credit cards is a guaranteed return on investment. This concept is broadcast all over the financial universe and it makes abundant sense. We’re in a uncertain economic environment with historically very low interest rates—how many guaranteed double-digit return opportunities are available right now?

Credit card interest is NOT tax deductible. All the time we’re paying it, we’re feeling the full force of it. This negates the tax advantages of retirement earnings, not the least of which since retirement savings are only tax deferred, not tax free. We will pay tax on retirement earnings at some point.

Some argue that by liquidating retirement savings we’ll have a guaranteed loss in the form of the IRS 10% penalty on early withdrawals, which is a fact. However, using once again our example of 3% guaranteed retirement earnings against 13% guaranteed interest paid on credit card debts, we’re losing 10% anyway. More significantly, the IRS penalty is a one time event, while the savings/credit card interest rate gap is repeated every year. We have to pay either way, but which is the lesser of the two evils?

We will have to add the amount of the retirement withdrawal to our income when we file our tax returns and there will be a cost for that. Assuming a 30% marginal tax rate plus the 10% withdrawal penalty, we’ll have to pay $10,000 on a $25,000 withdrawal. Where will we get that kind of money if we used the entire withdrawal to pay off our credit cards?

On a $25,000 credit card balance, we’re making minimum payments of $500 per month. If we liquidate retirement to pay off our credit cards in April of this year, by the time we file our taxes in April of next year, we can bank $6000 ($500 X 12 months) that we’ll no longer need to pay to our creditors. (Warning: don’t even attempt liquidation if you aren’t fully committed to redirecting payments into tax payments, or you’ll be trading one set of problems for another.)

Even if we don’t go through with this plan, we’ll still have to pay the same amount to our creditors, after which we’ll still owe something stunningly close to $25,000 one year from now. That’s just the way credit card debt works.

That’s $6000, where do we get the remaining $4000? Terminate retirement contributions and redirect equivalent funds to increase income tax withholdings until the full tax liability is covered. Don’t allow short term tax issues to prevent you from making long term financial improvements!

Sometimes we have to take a step back to go forward. This is an intangible factor, but one which is critical in reaching financial independence. If we’ve made mistakes in the past, such as accumulating outsized credit card debt, we can’t move into a better future unless we clean up our past sins. The sooner we do that the clearer the future will become.

In the example above, we will be liquidating $25,000 of retirement savings we now have, foregoing the tax deferred earnings on it, and not adding any contributions to it for as much as a full year. But remember, because we have $25,000 in credit card debt, our retirement savings are largely an illusion anyway. Because interest rates on savings are so low, we’re only giving up 3% guaranteed, or $750 in earnings. And the fact that we aren’t adding new contributions is only temporary.

Paying off debt is financial trench warfare, and there’s no cost-free, pain-free way to do it.

About a year after liquidating, we’ll still have $5000 remaining in retirement savings ($30K less $25K withdrawn to pay our debts), no credit card debt, no double digit interest to pay, no $500 per month payment to make, and we can resume making contributions to our retirement account at an even higher level because we have no debt. Sounds like a solid start to a brighter future.

Reminds me of the line in “City Slickers”–It’s a do-over!

Sometimes that’s exactly what we need. Wipe the slate clean and start over.

(Note: the example presented above is an illustration of a situation that isn’t at all uncommon. However, since all situations are unique by details and by degree, consider this only as a guide to one way of handling your particular situation. Not the least of which because there are tax implications, any step of this nature should be carefully considered against the specific issues in your own situation, and should be discussed thoroughly with trusted and knowledgeable advisors.)

Newsflash: You can’t get out of debt until you stop being broke!

By Kevin M

Some argue that if you’re in debt the priority needs to be to payoff your debts before attempting to build a savings account. Many call for the establishment of a small emergency fund—typically $1000—to handle contingencies, and then to pour all extra funds into the pay down and eventual payoff of debt. Only when your debts are paid will you have the cash flow to truly build substantial savings.

While there is some merit to that advice, I believe it fails to address the basic reason a person might get into debt in the first place: a lack of savings, forcing the use of credit as a savings substitute.

Until that cycle is broken, it’s doubtful you’ll ever payoff your debts or accumulate substantial savings. Life has a way of throwing contingency after contingency at us and unless we’re fully prepared to deal with that reality, getting out of debt is little more than a fantasy.

The vicious cycle of debt

I think most people underestimate the deep power debt holds over the debtor, and we often assume it’s simply a matter of a) stop borrowing, and b) payoff your debts. If only it really were that easy!

If you’re experiencing credit problems, either in the form of increasing debt levels or more frequent delinquencies, you’re probably also aware of one or more of the following:

• You probably don’t—and maybe never did—have any substantial savings
• Your credit lines function as your savings account
• Your debt levels have risen steadily over the years, despite the fact that your income has also risen
• You’ve generally been overly optimistic in your thinking, tending to assume higher income and lower expenses than has usually been the case
• The parade of “unexpected expenses” seems to be intensifying
• You may have developed a syndrome I refer to as “debtors optimism”—much like a gambler, the debtor assumes luck will be his savior
• You’re making the minimum monthly payment on your credit cards, promising yourself you’ll get more aggressive with payments later when…

Now a fat savings account won’t make all of these issues magically disappear, but it is a fact that a cash rich position does tend to make the ride in life a good bit easier, and this is at least in part because of the discipline having savings imposes on us. Just learning to live beneath our means—what ever those means may be—can be life transforming.

Make savings the priority

Why is it in your best interest to establish your savings before tacking your debts?

1. No one can be effective in carrying out any plan while being broke
2. While we’re trying to focus on paying off debt, bills are still rolling in, each one having the potential to force us to abandon the payoff effort in favor of putting out the immediate fire
3. Savings give you room to breath! Unless you have margin to fall back on when unexpected bills come in, you’ll panic. Panic is fear, and fear is in no way solid ground from which to conquer your debt problem or even to live life
4. Accumulating savings requires living beneath our means, banking windfalls and developing additional income sources—all of which will help in the later effort to pay off debt
5. In order to save, we must develop a more a realistic assessment of our finances; debtors optimism (or any form of optimism) won’t get the job done

Three to six months of living expenses in the bank should be the goal. I’m sorry, but the $1000 emergency fund won’t cut it—that’s little more than a nasty car repair bill today, and how unusual is that? One “emergency” and you’re back to being broke.

Once you have three to six months put away it’ll be time to tackle the debts. But even once you do, you should continue to increase your savings if only at a slower pace. After all, the same contingencies that put you in debt in the first place also have the potential to drain your savings.

Maybe it’ll take longer to pay off your debts this way, but if you have a cash balance to fall back on in emergencies you’ll have the time you need. In fact, one thing you may want to consider is a divide-and-conquer strategy in which you ignore your debts beyond making minimum payments in favor of maximizing savings.

Once you have the minimum put away (three to six months living expenses) continue saving until you have enough excess to pay off one of your loans entirely. You can continue this strategy of picking off one loan at time until all are paid—and throughout the process you’ll never have been broke!

If you agree that savings is the place to start before paying off your debts, please read Start and Grow Your Nest Egg Even If You’re Broke for some ideas on how to get started. Once you have a few months worth of living expenses stashed safely in a savings account you’ll begin to feel better about your whole financial situation, because it will be better!

Which way do you think is the better way to get control of your finances, build your savings first then attack your debt, or go right for paying off the debt and build savings later?