Freedom From Debt

Self help author Bob Proctor said:

If you’re thinking of debt, that’s what you’re going to attract.

It is true, if you spent all your time thinking about how much debt you are in, you may feel helpless and lose the fortitude to move forward in relieving yourself of debt.  The irony is, thinking of saving (the opposite of taking on more debt), may be just what you need.

Debt and spending is closely tied to savings, the more you do of one, the less you have left over for the other.  The more savings you have, the less you often need or want to borrow.  Since you’re paying out interest by borrowing, and therefore likely not getting interest by saving, you’re burning your financial fuse on both ends.

When your debt servicing chews into not just your checking account but also your savings for retirement, you have a bigger issue to consider.  An Individual Retirement Account allows you to set aside money for your later years which has multiple benefits and only a few risks.

When you put money into your IRA, obviously, you are not spending it.  You collect interest on the money saved which will compound over time.  See one of the many online calculators or read about the rule of 72 to get a feel for how compounding can help turn a few thousand dollars into many thousands of dollars over time.  In addition to the interest aspect, in funding your IRA you also get a tax benefit since, by design, any money put into the account represents a tax deduction.

Instead of being taxed on the money you put in now, you are taxed on that money when you begin to use it many years later. The idea being that later in life you will likely be in a much lower tax bracket and therefore will pay a much smaller amount than you would if you pay taxes on it now during your working years.  Here is a link to historical tax rates if you’re curious how our current rates compare to those of the generations before us.  While the logic to sock money away now tax-free to pull it out later as taxable income is good advice for many, it doesn’t make sense for everyone.  Luckily, there are now a plethora of retirement account options available to you.

One variation, for example, is the popular Roth IRA.  You pay taxes on each dollar you put into the account as you would normal income, but federal regulations allow tax-free withdrawals as long as the contributions remain in the account for five years and you are at least 59½.  There are many financial planners these days preaching that you should put a part of your portfolio in pre-tax and part in after-tax retirement accounts so you can balance your tax situation when you start making withdrawls.

Another common savings instrument is the 401k.  401k accounts allow employers to put money that is tax-deferred into accounts on the employees behalf. You pay no income tax on the money until it is withdrawn.  The same risks apply as far as taxes go to the IRA account specifics detailed above.

For folks who have diffcult with the willpower needed to save, 401k are often a useful tool because the withdrawls are usually just pulled straight out of the earner’s paycheck.

The point of this article isn’t necessarily to offer advice to which type of account is best for you, but to recommend making contributions to some type of retirement account.  If you get your mind off  ‘debt’ and onto ’savings’, your positive mental attitude may have a seriously positive impact on your financial health down the line.

Of course, the title of this post is an exaggeration on both sides. Credit cards are neither a friend nor a foe.  They are a merely a tool, and how you use them (or abuse them) is what will determine whether they help you or hinder you in your progress to becoming debt free.

A credit card can be used for the sake of convenience, for online shopping and the dozen other uses for which it was designed, none of which are necessarily a bad thing.  For others, a credit card can become a means of increasing revolving debt to unmanageable levels, requiring the borrower to pay obscene amounts of unnecessary interest every month.

Many who let credit card debt get out of control see debt consolidation as the way out. They are often presented with a stack of offers to reduce their credit card debt by consolidating all their debt onto one card.

But those offers, though they frequently tout ‘lower interest rates’ should be viewed with a skeptical eye. Those lower interest rates are usually only available to a select few with very good credit ratings. That doesn’t apply to the typical person who is struggling to overcome a history of excessive debt and find a way out.

But, they can offer a way to solve the problem over the long term. You may, in fact, be able to qualify - the only way to be sure is to apply. But even if you’re accepted, there are several key items to keep in mind when considering this solution.  If your credit is in very bad shape and you suspect it will be unlikely that you’ll be approved, you may want to not even apply as excessive inquiries into your credit report via loan applications can actually harm your credit score.

Very rarely will such credit card offers lower the actual amount of principal outstanding.  As a result, you have exactly the same amount of debt on the day you acquire the new card and, over the long term, you will actually sometimes pay more.

A lower interest rate can obviously be a benefit, but lowering the rate doesn’t always mean lowering the total amount you’ll have to pay to relieve the debt.  If you pay 8% on a debt of $10,000 for, say, five years you will pay more than paying 10% on $10,000 for two years.

The reason for this is the compounding effect of interest. The total amount of interest paid in the first case is $2165.60. The net interest rate overall is 21.656% when calculated as the percentage paid beyond the principal. In the second case, you pay only $1074.80, with a net interest rate of 10.748%.

Remember the 8% vs 10% are the APR in each scenario. APR means the annual percentage rate, this is the rate for a one year period, not the total percentage of interest.

Of course, the upside is that in the case of 8% over five years, you pay only $202.76 per month, in the second case you pay $461.45 per month. Many will find the former payment easier to manage than the latter. And, you may be able to find some middle ground. Calculators available online will help you run through the different scenarios, in order to guide you to choosing the one that’s best for you.  Assuming you have no prepayment penalty (unlikely on a credit card), if you have some discipline you can get the 8% card and just pay the extra money towards the principle every month.  Minimum payments are not your friend, regardless of the interest rate on your card, you’ll need to pay more than the minimum each month to make significant progress toward relieving your debts. 

If discipline is not your specialty, considering a consolidation loan with fixed payments over a pre-determined time table may be a better way to resolve your debt.  Several online lenders offer fairly competitive rates these days and, as long as you make your payments when due and stop taking on additional debt, you will have an exact date that you will be debt free.

I just got the new issue of SmartMoney in the mail and its got a great article called “Live Debt-Free” in it.  It has tips on debt consolidation, improving your FICO score, different types of debt, playing the 0% interest juggling game, etc.

Unfortunately, the article isn’t available on their website, but its worth picking up a copy off the magazine at the store if you want a nice, comprehensive article on managing your financial debts and building a plan to becoming debt free.

I just built an Amazon Store for this blog, you can check out the magazine section here.  SmartMoney is only $12 per year or $18 for two years…its a bargain.

Turning up the heat

As you can imagine, there are multiple approaches to reducing your debt levels, some less painful than others.  The obvious and most widely used approach is to just pay the minimum on all your cards and a little extra here or there as your budget allows.  While this approach can eventually succeed, it can take a very long time before you see significant progress and it takes great determination to keep up with the somewhat Laissez-faire approach without any structure, clear strategy, timeline, etc.   For those with large debt levels, using a unstructured approach to tackling your debts can leave you with a hopeless feeling. 

This article is all about one debt reduction approach.  It may not work for everyone, but its simple, effective and very structured.  The approach we’ll cover in this article is called the “snowball method” (so named by Dave Ramsey).

The technique

The technique is, in essence, very simple. Order your debts from lowest to highest. Pay the minimum required on all monthly debts, then allocate any remaining funds you can to paying off the smallest debt. Thus, the smallest debt will get paid off first. This frees up yet more money to apply to the next-smallest debt. Repeat until you have reached the level you want.

The snowball method has several advantages.  By “snowballing” your debt payments, you’ll see regular, visible progress in reducing your debts and, in a relatively short period of time, you could well be down to a livable level. As you roll-off those debts, you have more free income which can be split between payments on the debt next in line and the enjoyment of some of the rewards of having less debt (more disposable income, more money available to put towards retirement, less stress, etc).

Psychology is king when it comes to reducing your debt

Psychologically,  the snowball approach helps keep the debtor motivated to continue the program. Seeing real progress helps one stick with it during a financially challenging period. 

One can get carried away with attacking high-interest loans first which is, technically, a better approach in the long run for in regards to total interest paid but the psychological benefit of the snowball approach should not be underrated.   Seeing your number of outstanding loans decrease month over month or year over year will keep you going.  You’ll see tangible results.  Snowballing the debt payments will also help to keep you disciplined as you’ll know exactly how much you should be paying every month toward eliminating your debts.

Don’t be distracted by credit card “rewards”

By rigourously adhering to the snowball approach, you’ll know how much you should be paying each month and won’t fall victim to credit card trickery.  Keep in mind credit card companies don’t really want you to pay off your debt.  If you pay it off, they’ll make no interest off you.  As you start to decrease your debt levels, don’t be surprised if your credit card offers you a lower minimum payment on a given card or a ‘payment-free’ month.  Its their attempt to keep you paying interest.  When they make you this offer on the snowball approach, you can either ignore it entirely or, if that card isn’t your card with the lowest balance, you can apply that month’s payment to your current snowball target. 

Once you’ve started attacking your debt, consistency and determination are key.  You need to stay motivated and get positive reinforcement to continue your debt reduction cycle.  The snowball approach to reducing your debt offers you strategy, rigidity, and a very rewarding system to start reducing your debt levels immediately, starting with this month’s payments!

Get the facts

The first step to handling any problem, and excessive debt is no exception, is to focus on facts. In regards to managing your debt, focusing on the facts means finding out how much debt you really have, what kinds of debt you have and what the monthly payments and interest costs are on your debt.  This post is the third article in my series about debt.  The first article introduces you to your credit report and the second goes into detail on the FICO score that you will get back when you request your credit report.  Armed with your credit report and FICO score, you’ll be able to have the pieces to put together a ‘debt inventory’ of the accounts you have open, balances you are carrying, minimum payments on each account and, with a little extra work, the interest rates you are paying on each account.  Doing the work to find out the interest rates on your various accounts is optional in taking your ‘debt inventory’, but will allow you to more easily prioritize which accounts you should pay off first.You may be surprised how many people are troubled by debt problems, but haven’t done the work to calculate how much monthly interest they’re paying to service their debt.  Part of the problem may be that they really don’t want to know and, considering how much it sometimes is, one can hardly blame them.

Research your interest rates

Fears and denial aside, the first step back to financial health is a good diagnosis.  Call your creditors, check your latest statements online, or dig up your most recent paper copy of your credit/loan statements to determine the interest rates on your various accounts.  If you’re paying $200 per month in interest charges alone on a monthly net income, say, of $4,000, then you are paying 5% per month of your income for essentially nothing.  It’s not entirely nothing, since you are enjoying the things you bought early (instead of saving and purchasing with cash), but you should be honest with yourself and question whether being able to make those purchases early is worth 5% of your income.

When that $200 a month becomes the total you can pay each month, you have reached a point where you will never pay off the debt.  If all the money is going to interest, none is going to principal.  Some sources say paying the minimum payment on credit cards often takes around 8 years to eventually pay off the balance…thats IF your credit card company even requires you to pay any principal every month, some don’t.  Take a look at a past statement and consider how much of the monthly payment goes toward interest versus repayment of principal.

Suppose it’s 90% interest, 10% principal. That’s approximately the case for the average home loan for the first several years. You can use an online calculator to see how long that will take in your situation.

Suppose, for example, you owe $10,000 at 7%.  You could pay only $116 per month, but it would take you 10 years to pay it off.  The interest would cost you $3,933 - almost 40% of the total amount.

Debt Repayment Techniques

Now that you’ve seen your situation, you need to take two further steps. Develop a budget that will allow you to make payments as large as you can handle to get the bills paid off.  If you have several accounts, you could use the ’snowball method’ (I’ll post a future article on the details of this approach) and pay off the smallest one first. Then apply what you were paying to the smallest to the next smallest (now the smallest), until you’ve reached the end.  This ’snowball approach’ quickly builds up your payments each month and will allow you to start to tackle even some of the largest debts in your ‘debt inventory’.  If you only have one loan or credit card, fancy debt repayment techniques aren’t necessary, just pay off as much of the debt as you can afford each month.  Make it hurt if you need to, you’ll be glad you did in the end when you are debt free!

The alternative to the snowball approach is to just take on your largest debt first. That would save you the most in dollar for dollar interest each month (though other accounts may have higher interest rates), but it’s hard for many people to stick to this approach when they see such slow progress.  Start simple, snowball to kill off your smallest debts first.  You’ll see progress, build discipline, and rapidly start to build up your snowball to tackle your larger balances.

Stop Taking On New Debt

Now, for the hardest - and most important - step of your debt management process (which should be carried out simultaneously with the first)…stop borrowing. You should not allow yourself to incur any further debt until you have gotten your existing debt under control.  That ‘reasonable level’ varies on your types of debt and your own will power.  Make sure to make steady payments so you can see progress.  Making progress will boost your desire to further control your debt levels and having the desire to do it will motivate you much more than any article or book will ever do.

Facing reality and making a commitment to long-term change are the two hardest things for anyone who has entered financially turbulent waters to do, but honesty about your situation and a plan for controlling it are critical if you want to recover your financial health and independence.