Many Americans are in debt. Car loans, credit cards and student loans are the three most common offenders that linger in many family budgets. If you find yourself in this situation, you are not alone. Many American households are currently living paycheck to paycheck with no end in sight. This amount of debt is unacceptable in the world's richest country. Something has to change as people continue to slip further in debt and their children watch and learn these bad behaviors.
Good spending habits are easy to explain. Do not spend more money than you earn. This allows you to keep debt at bay and out of your life. Many people probably would not own a car if there were no such process as a car loan. We have taught ourselves that borrowing money is the only way to survive. When we discuss loans, many people say that they have no problem with taking on multiple loans to fund their lifestyle. This contradicts the idea of spending less than you earn. Just because you can incrementally pay for an item along with the interest does not mean you can afford the item. You are essentially renting the item from the lender and you paying them for assuming the risk of loaning you money. This makes them rich while you continue to stay in debt.
People with good spending habits do not borrow money, they save what they earn, then make decisions to write checks for things that fit into their budget. This philosophy allows even the most modest earner to save for a long retirement. Think how much money you could save if you had no loans to repay to a lender, even including your mortgage. Once you achieve financial freedom, you can begin saving for retirement very quickly because the portion of your budget previously reserved for loan repayments can now go towards investment accounts, which helps you get ahead.
Over the past 20 years, I have developed a simple but effective plan that eliminates debt in a six-step approach that allows you to take over your spending habits and focus on debt elimination. If followed correctly, you should be able to eliminate the majority of your debt excluding your mortgage well within 30 months. This is not a very long time considering the average car loan is for over 48 months.
Step 1 is to build a budget. This sounds easy but many people have not sat down and built a budget to explain where every dollar they make is spent. In fact, if you were to ask a few people what their total monthly expenses amount to, they would probably have to begin by writing it on paper. Every household needs to follow a strict budget that is transparent and enforced. I bet the company you work for has a budget. I also bet your employer knows how much their monthly expenses are. This is because they do not want to default on any payments and your household should be ran the same way. Take the 30 minutes and write out an itemized budget.
Building your budget achieves three main goals. First, it enables you to see where you are spending money, which makes it easy to make some sound financial decisions. Next, it allows you and your spouse, if you have one, to be on the same page so you understand each other's spending habits. This is important, you and your partner must financially unite or none of the other steps will work. Lastly, it tells you exactly how much money you have leaving your household. This information is very important leading into step 2.
Part of putting together your budget also includes eliminating extra expenses or at least putting some on hold. One that many may find difficult is the retirement accounts contribution elimination. Do not worry; this is only a temporary situation. Once everything but your home loan is paid, you will continue to contribute to your retirement accounts. It may seem risky especially if you have only a small nest egg but overall stopping these contributions allows you to throw more money at your debt, which ends the debt faster so you can contribute more to retirement later. If you were previously contributing $300 to an IRA with $30,000 in debt, after you pay off the debt, you can bump up the IRA contribution and max it out.
There are many ways to distribute the money in a monthly budget, which I will talk about later but here are a couple quick notes. Some rely on the 50, 30, 20 rule. This means to allot 50% of your budget to fixed payments such as car and home loans. The 30% goes to variable payments such as electricity and groceries and the last 20% would go to savings and investments. This strategy does not meet every household's goals, especially when trying to pay down debt so I recommend that the numbers not be addressed until you are out of debt, excluding your mortgage. This allows you to set realistic expectations for your debt reduction timeline. Only after you have paid all the debt except the mortgage, should you use any percentage rules.
Step 2a is to create a small starter savings fund that is only for emergencies such as the car breaking down or you missing a day of work because you are sick. Different financial advisors recommend different standard amounts but I believe one set amount is not safe for every situation as some have more people in their household, which equals more liability. The numbers I recommend are $1,000 for singles, $1,500 for married and no children, then $2,000 for married with children. Again, this fund is only for unplanned events and anything outside of this small fund will have to come from the monthly budget. For many households, this alone might take a few months to build but stick with it because it is important to establish a financial buffer prior to step 3.
Step 2b is to grow and expand your income, if possible. Services like Uber and Lyft allow people to earn additional money with very little additional effort. You could also deliver pizzas, walk dogs, mow lawns or babysit in your spare time. Regardless of what you decide to do, the math tells us the more income you create, the more you can attack your debt. Filling your spare time with additional jobs makes it easier to disconnect the cable television service and lose that $150 a month bill.
Step 2c tells people that if any bills have gone to a collection agency, it is your responsibility to settle those debts and put them into your step 3, if not they will continue to haunt you and your credit score. While calling these agencies, you should know exactly what the debt was prior to any late fees. This will be your advantage when negotiating a payoff. I have seen an original $400 bill go over $900 after additional fees were added. The collection agencies buy those default accounts and try to collect whatever they can to earn a profit. If you give them $900, they will be ecstatic but you would have wasted your money. Begin the conversation by asking them the best offer to settle the bill. They will probably drop to what you originally owed but that is not their best offer. Kindly tell them you do not have that much and offer them one quarter of what you owe them. They may or may not accept it but just realize you can definitely negotiate the payoff. Also, ensure you request a signed letter stating the amount negotiated will clear the debt before you send any money. If possible, send by money order so they do not have access to your bank accounts.
Step 3 is what many people refer to as the debt snowball or sometimes the debt avalanche. You take all the debts, put them in order of lowest to highest total amount owed, and pay them off in that fashion. While doing this step, you pay only the minimums on the other higher debts and throw all additional money beyond your monthly budget at the smallest debt. I do recommend this method but I also want to save you as much money as possible so I throw a twist into this typical strategy. I also recommend mixing in what is called the laddering method. For any high interest loans, such as credit cards, payday loans or anything above the 10% range, I pay those off by highest interest rate first. This saves additional money because you avoid letting the high interest rates to linger. If you let them stay while only paying minimums it could cost you hundreds of dollars in interest. Take this example; you have a $25,000 student loan at 3% interest, a $8,000 personal loan at 9%, a $9,300 credit card loan at 28% and a $6,000 car loan at 5%. The snowball method tells you to do the car, the personal loan, the credit card and then the student loan. This will work just fine however; you will continue to pay a very high interest credit card payment, which will cost you more money because your minimum payment is probably not covering the interest that is gaining on the principal. I would recommend you attack the highest interest in this situation then revert to the snowball method. Remember; only attack the high interest items, typically credit cards and payday loans in this fashion, then continue the debt snowball method. Therefore, this example will have you pay the credit card first then the car, the personal loan, and finally the student loan.
Remember, this step only works if you are all-in and fully devoted to the outcome. For some it might only be 6 months while others take 36 months to eliminate their debt. You cannot continue to use credit cards, eat at restaurants or purchase items not on your monthly budget. Use your step 2 starter savings fund sparingly. It is only for real emergencies, if you have knowledge that you will need money in the future, it should be part of your monthly budget.
Step 4 is to finish building your emergency savings fund. At this point in your journey, you have paid off everything but the house so you have much more available income to set aside for a rainy day. Some financial advisors have a set amount they feel comfortable advising their clients but I really base it on your total situation. A single person has more risk because there is only one income to rely on, if the job goes away, then all of their income goes away too. Married people share the risks however, not all jobs are stable, and some people have commission-based jobs that do not provide steady income. Then there are people with children. In these scenarios, a household with children but only one income has some serious risks to evaluate. I typically tell clients to look at a span of 6 to 12 months. If you believe you have a low risk factor then you can have an emergency fund of about 6 months of your household expenses. This is if you are single, your job is stable, maybe your mortgage is paid and you have mutual funds available if you need to liquidate additional money. Not many people fit this billet so just remember if you lost your job, you must factor in how long it might take to find another one. For many families this may fall in-between $12,000 and $24,000, depending on your situation and lifestyle. This is not some large slush fund. Save what you need and move on to the next step because at this point, if you have an emergency, you will have this fund and you should have retirement money through mutual funds.
Step 5 is to focus your money on your investments. Your investments, for this step include your children, your home and yourself but not necessarily in that order. You can prioritize the investments in any order you choose and reconstruct your budget with percentages. Before you begin, you should take into consideration a few factors. The age of your children could drastically affect the way you will invest for their college budget. If you have teenagers and no college funds at all, you will have to develop a strategy to not only catch-up but you will also have to include a school and job option because your investments will not be able to gain much traction in that short time. If you have young children that have not entered kindergarten, you might want to invest in a 529 Plan or Coverdell Education Savings Account. As always, research your options and decide which one works best for your situation and be aware the federal government may change contribution and income limit rules for these investments annually. Generally, if you have the money, you might want a 529 Plan because you can contribute large sums of cash, depending on the plan and just leave it to grow. The Coverdell Education Savings Account currently only allows $2,000 a year in contributions but if you invest that much for just 10 years, you will still have a hefty fund based on the growth potential when loaded in decent mutual funds. You should also consider the age you would like to retire. Again, this is relative to time and your situation. You may decide you would like to have a job well into your 70s whereas others may want to retire at age 50. If you began saving for retirement at age 20, your percentage of your budget dedicated towards retirement could be lower and more money could go toward your kid's college fund. Your home is your largest tangible investment you will probably own. When throwing additional money at this loan it is important to focus these funds towards the principle. This is how to pay it off faster. Consider this step complete when you have fully funded the college budget and paid off the mortgage.
As stated earlier, a financial advisor could advise different percentages based on your particular circumstances but you should understand it is your money so you can do whatever you want. I have a couple scenarios that might help you decide. If you have not saved for college or retirement, you might want to structure your budget as 45% for mortgage, 20% for retirement, 15% for college and 20% for the rest of your expenses. In this scenario, a household bringing home $77,000 a year after taxes gives $34,650 a year to the mortgage, $15,400 to retirement, $11,550 for college and $15,400 to daily expenses including escrow but not the mortgage. If this is too tight, you can reduce the amount paid on the mortgage but this scenario pays off a $300,000 mortgage in about 8 years. You can adjust the percentages by considering the mortgage as connected to daily expenses and retirement as connected to college funds. To make a modification, just pull from the connected fund to keep them balanced. If you have some college money already saved and no retirement, maybe you send 45% to mortgage, 25% to retirement, 10% to college and 20% to daily expenses.
Step 6 is to continue funding your retirement accounts and enjoy life. Making it to this step is difficult but because you have done everything right, you deserve to enjoy the lifestyle you created. At this point, your budget might even have 50% invested in retirement accounts. You may be over 50 years old, which allows you to contribute even more to your 401K and Individual Retirement Account (IRA) by using the catch-up provision. Again, do your research because the federal government adjusts the income and contribution limits for these retirement plans.
Part of enjoying life may include traveling, giving or some new hobby; that is okay. You now have the money to do anything that reasonably fits into your budget. You do not have to be as restrictive as you were in the beginning steps but do not let that be an excuse to get out of control. Continue to manage your money with your spouse and share your experience. Pass on your story as motivation to others and teach them how to manage their money and to eliminate debt.
Some people need a jump-start when they begin the debt elimination journey. I have compiled some tips that will help you speed to the finish line a little faster. Just remember, you have to be committed if you want to succeed. For this reason, I challenge you to adopt some if not all these additional ideas because in the end, they will get your debt eliminated much quicker.
Is your cable bill over $100 a month? I bet you could give up cable television for at least one year and not miss a thing. If $1,200 a year is not enough motivation then I would also tell you that after one month without cable you will notice you and your kids have a lot more free time than you realized. Use the free time to earn additional money doing something else. If you absolutely need the entertainment, consider alternatives such as Hulu, Netflix or Amazon Prime. These are very cheap when compared to cable and you still get many good viewing options. Additionally, do not forget to purchase a digital antenna for your television. If you live in a populated area, you will probably be able to get a least a few local channels free.
Do you have a self-storage unit costing you monthly for stuff you literally forgot that you still own? Does your garage at your house have everything in it but your car? If you answered yes to these questions then you probably need to have a garage sale. People will pay you to haul away stuff that you do not need. How can you go wrong there? If you are paying $50 a month for your storage unit, you will save $600 over the next year.
If you have not shopped around for new home, renter or auto insurance in the last 3-5 years, you might be missing some savings. Each year when your policy comes back for renewal, get a couple quotes from other providers just to see if the price you are paying is still the best option. You might be surprised because your carrier is not necessarily just going to lower your price, even if they have lowered their rates. You must be proactive, ask the question and shop around.
If you have a cell phone contract with one of the major carriers such AT&T, Verizon and Sprint, you might want to shop around other alternative carriers like Cricket, Straight Talk or even a pre-pay phone. I know this might seem overboard but if you have a contract that is costing you over $100 a month for one phone, realize there are cheaper plans that could bring your bill down to around $50 or less a month. Of course, this does not mean to pay $300 in fees to get out of the contract and only save $10 a month. You must make sure if you break your contract, the fees are worth the return on investment.
Another expense that could probably be temporary dropped is your gym membership. If you have time to go to a gym and workout, then you probably have time to work a second job and increase your wages. Your health is very important but it is a long-term goal just like your retirement, which you can stop temporarily while you work your way out of debt. Try jogging outside at a park or going on YouTube and working an exercise video at home, both of which are free. If you pay $30 a month, you just saved $360 over one year.
Do you know anyone that stops at a coffee shop every morning and drops $10 on coffee and another $5 on a pastry? That equals $75 a week or $300 a month for some morning pick-me-up. If it is that important to have caffeine and sugar every morning, and for many it is, then may I suggest you brew it at home and save $3,600 a year. Another offender that falls into the same category is your lunchtime routine. If you are dropping another $10 everyday on lunch instead of bringing your leftovers then you can add another $50 a week and $200 a month. Please do not throw away another $2,400 a year.
Moving down in vehicle might be another money saving idea that could potentially save you thousands but many times the math does not add up. If you are making $40,000 a year and have $75,000 in debt, a $300-$500 car payment is killing your ability to pay down your debt. Even more upsetting is the fact that your vehicle depreciated so now you owe $18,000 on a car that is only worth $10,000. You must now decide if moving down makes sense in your situation. If you save up $3,000 to buy a used car and sell your current car through a private sell for $10,000, you have technically traded an $18,000 debt for an $8,000 debt with it costing you $3,000. In the end, you really only saved $5,000, so you must decide if it is worth the trouble.
The last recommendation might require some outside assistance or at least a partner to help share in the experience. I do not smoke cigarettes however; I know it is an expensive habit. If you are able to kick it, you could easily save $30 a week or $1,440 a year.
Beginning your journey to financial freedom can overwhelm the best of us. You have to stare directly at debt even it is two to three times your annual household income. Do not let it defeat you, attack the debt as if your financial future depends on it because, it actually does. Math will tells us if you have more money going out than you have coming in, you will have a deficit which could lead to using a credit card to fill in the gap. Sell your stuff, work extra jobs, do whatever it takes to rid yourself of debt. Eventually it will be gone and at that point, you have won. You have stop paying for your past and can begin saving for your future.
If you have any questions, comments or would like to schedule a private debt consultation please email me at Coastal.Finance.Group@insurer.com.
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