Debt Reduction for the Willfully Stupid

Photo by: kainr

People get into debt in a variety of ways.  Some people have medical problems or other things that are largely beyond their control.  Others have simply traded their future earnings for current creature comforts.

While the ways in which people get into debt are varied, the ways out really aren’t.  A lot of people try to make debt reduction complicated.  It isn’t.  There are a few basic moves that will get you out of debt, but they’re predicated on being realistic, accepting that you’ve already had more fun than you’ve earned, and it’s time to redress the balance.  Even if your debt is the result of things beyond your control, here’s some basic advice for those who feel like it’s time to be realistic about how to get out.

Cut Your Expenses

So you have a certain standard of living you’d like to maintain?  Too bad.  When you’re in debt, every dollar you spend costs you that dollar, plus all the financing costs until all your debt is paid off.  Let’s take a simple example.  If you have a 20% APR credit card and it’s going to take you 3 years to pay down your debt, every dollar you spend is actually costing you over two dollars.  That’s without taking into account the fact that a penny saved is more valuable than a penny earned after taxes.  That five dollar burger is now going to cost you ten dollars.  While this ignores the effect of inflation, you get the point.  Putting that dollar towards debts was the better move.

Get a Second Job

Many people are very concerned about their free time.  If you have debt, you’ve already spent your future free time.  When you bought that flat screen TV on your credit card, you were trading your future free time for a TV.  Doesn’t seem like such a good trade now?  Imagine the impact of another twenty hours of work on your ability to pay off your debts.  Assuming you’re at least in the black and slowly paying down your debts, you can put every penny you make at your second job toward your debts.  While you’ll lose some free time, you’ll reduce the stress that all that debt is putting on you. (more…)

Investing Prerequisite #2: Expanded Emergency Fund

Photo by: Dumbledad

This post is step 2 in our Investing Template.

Many people will debate the details and priority of this, but quite simply there is no reason to begin investing until you have enough liquid cash to survive for a reasonable period.  Unfortunately, this can mean different things to different people.

What Kind of Survival?

One pivotal question in figuring out how big this fund should be is how you would like to live during a financial emergency.  Suppose, for example, that you lose your job; are you comfortable cutting expenses severely so that you can keep more money in better investments?  The stress of finding a new job may be enough on its own without deprivation to boot.

Additionally, you need to really think about which expenses are necessary.  While you don’t want to keep too little in your fund, you don’t want to keep too much either.  This is an emergency fund, so you don’t necessarily have to keep every element of your current lifestyle during this emergency.  You can probably eat out less and see fewer movies, but would want to keep enough funds to pay for your kids’ private school.  Use a budget (you do have one, right?) to get a real idea of what you would need per month to survive and what you want that survival to look like.

What Is A Reasonable Period?

Once you know how much per month it takes you to live, the next question is how long you would reasonably need to live this way.  While some people advocate fairly small emergency funds, it is often desirable to put away enough money to live for a considerable amount of time.  If you lose your job, you don’t want to be forced into taking an inferior job, or cash out investments prematurely, simply because your money is running out.  You may have a realistic idea of how long it would take you to find a job, but I say be very pessimistic when enacting your emergency fund.  I believe 3 months living expenses is a minimum. This is only my personal opinion, but I think giving up potential investment returns is well worth the security this extra time buys.

What is Liquid?

Liquidity is a measure of how quickly you can get the cash.  The most liquid accounts are savings accounts or money market accounts.  Accounts where you can either write a check against it, or get the money into a checking account within hours, not days.  Generally however, liquidity comes with a price.  The more liquid an asset, the worse the returns typically are.  Certificates of Deposit (CDs) for example, offer better returns generally, but require you to leave the money on deposit.  This may sound like a deal breaker, however an ideal solution can involve CDs.

CD Ladder

For those who wish to have a large emergency fund, but don’t want to earn terrible returns on the money, a CD ladder may be an ideal solution.  A CD ladder is a series of CDs that mature often enough that you can use them as your emergency fund.  For example, you might go every month and open a 6 month CD with enough to live on for one month.  If you did this every month for 6 months you would now have a CD ladder.  Every month a CD will mature with enough for you to live on for that month.  If you need that money, retrieve it and don’t allow the CD to renew. If you don’t need the money, leave it there and allow it to compound.  There are many tricks and optimizations for starting a CD ladder, but it can be an optimal way to build your emergency fund.

Now that you’ve eliminated your debts and created your emergency fund you are ready to start making more intricate decisions for your investment strategy.

Investing Prerequisite #1: How To Deal With Debt

Photo by: SqueakyMarmot

This post is step 1 in our Investing Template.

Deciding when and how to pay off your debts is not a simple matter.  While it can be comforting to be debt-free, that may not always be the most financially expedient approach-nor is it the whole picture. Here are a few steps, including analyzing and paying off debt, that really make your money work FOR you.

Step One: The Basic Emergency Fund

The absolute first thing you need to have is something to pay for unforeseen events.  I personally recommend keeping this fund as small as possible at the beginning.  We’ll get to creating a larger cushion later, but right now the goal is simply to get enough money so that you’re covered if your car breaks down or something else untoward happens.  In fact, in some cases I’d recommend skipping this step altogether.  If you have friends or family you believe you can reliably rely on in case of an emergency, get right down to paying off any debts.  Once your debts are paid off, go on to creating an expanded emergency fund.

Step Two: Minimum Payments

Paying off your debts is one of the best investments you can make, but it isn’t always the best.  You need to take a lot of things into account to decide when and how to pay off your debts, and the analysis isn’t always simple.  One main rule is this:

Always Pay Your Minimums

You cannot possibly hope to match the interest rate you will be charged with late fees and penalties, so you have to pay at least the minimum to every debt you have.  So no matter what other options are open to you, do not let yourself be subjected to these kinds of charges.  If you cannot meet your minimum payments, it’s time for another job, or to sell some things.  Getting your head above water is a separate subject, but make sure to do it.

Step Three: Tax-Deferred Options

Now despite the allure of being debt-free, there are some rare occasions that your bottom line will be better served by contributing to your tax-deferred savings.  Quite simply, if your company matches your tax-deferred account at 50% or better, you may be better off contributing to that account.  This is of course only true up to the amount that they match. Do not contribute more than they match until your debts are all paid off.

For example, if my company will match up to 3% of my salary in my 401(k) at 100%, I am possibly better off making this contribution instead of paying off my debts.  I will make 100% return on that money put into my 401(k), while I will probably be charged 20% on the debts I leave unpaid.

Generally speaking however, unless your debt is relatively small compared to your income, or you are very secure that your income will continue, you are probably still better off just paying the debt.

Step Four: Pay Off Your Debts

There is no sense investing in anything when you have the option of paying off your debts.  The only debt you may want to carry is a house or a car, and even those are questionable.  Even beyond the dangers of high-interest debt, it simply provides a security blanket to have your debt cleared.  There are various approaches to paying off your debt, but get it done before you start investing your money elsewhere.  Moreover, when in doubt: pay off your debts sooner than later.