Category — Debt

Today the last payment went through on one of my credit cards, which means I am now officially down to one credit card, and last month’s camera is paid off.

Now that we are down to one credit card, which has a 0% offer, and my student loan, we plan on switching gears slightly. Due to problems with my wife’s unemployment checks (their timeliness sucks), we are going to boost the amount of money going into the emergency fund for a few months so we have enough money to cover the rent if times get bad.

As of today my wife’s student loan and credit card are both paid off. Next week I will pay off the first of my credit cards, leaving us with my student loan and a credit card at 0% interest. It is a great feeling to be hitting these milestones.

We are still using the debt snowball method to pay off our debt which has been great for keeping the motivation up. We are also fans of the debt snowflake, which has helped pay off our debt much faster than we originally thought by putting extra money towards paying off debt.

By far the most difficult part of getting out of debt is not incurring more debt. A while back I started an extra savings account to save for new gadgets, namely a new dSLR camera. But every time I save a decent amount of money in the account I decide that I would rather put that money onto my credit card to pay it down further. It has been great for paying off debt, but not so great for me actually getting a camera. So far I have been patient, but it’s getting tougher to resist the siren call of spending.

Flexo at Consumerism Commentary has a post about frugal lifestyles and whether we are missing out on some of the fun things in life. I completely agree with the analysis, and feel that it’s important to strike a balance between planning and saving for the future and enjoying your money now.

The followup article was also interesting, noting that actually having money provides a lot of freedom that “stuff” will never provide, particularly freedom and time. When you have enough assets to cover your living expenses, you no longer have to worry about a job and you are free to do whatever you want with your time.

How does this fit in with me wanting a new camera? Right now I still owe a lot of money on my credit card, and I feel that no matter what paying that off is priority #1. Although I would rather spend my money on fun stuff like gadgets and vacations, my debt is not going to go away on its own. My debt was incurred buying “fun stuff” when I couldn’t actually afford them, and now I am paying for it (with interest no less). But once that debt is paid off I shouldn’t feel so guilty about spending money, as long as the spending is kept within reason. On the bright side, I still have a lot of cool stuff sitting around to keep me occupied until then!

I just hope that I can keep up this mentality for another year while I continue to payoff debt and then build an emergency fund. Patience will be key.

Anyone care to comment on when they think it’s okay to spend money versus saving it for the future (especially if young ones are in the picture)? Cheapo, I know you’re out there somewhere! Let’s hear your thoughts!

Just a quick run through some numbers to get you thinking about another reason you should try to reduce your expenses and save for retirement.

Suppose you had $400 in monthly debt payments, and your tax rate was 20%. You would have to earn $500 a month before taxes to make a $400 debt payment. So once that debt is paid off, you can now contribute $500 a month to a pretax retirement account such as a 401k or IRA and still maintain the same budget you had when you were making the debt payments. So now not only are you not paying interest on your debt, but you can now save an extra $100 a month not paying the tax man. That works out to an additional $1200 a year that you can keep to yourself on top of the $4800 saved from not making debt payments.

Now of course if your tax rate is higher you will save even more money by paying off debt and investing in a tax advantaged account. If your effective tax rate is 30%, you will need to make about $572 to make $400 after tax. [$572 * 0.70 = $400.40]

Pay off that debt and you will have $6864 that you could contribute to a retirement account. With that retirement account growing at 9% a year tax free, you will have over $1 million in about 30 years. Start doing this at 30 and you can be a millionaire by the time you’re 60. And thanks to the miracle of compound interest, you will have $2 million in another 8 years at 9% interest. All because you reduced your expense $400 a month. Pretty cool, huh?

Stay tuned as I start a series on retirement accounts and investment decisions. And as always please fee free to leave a comment with any questions, or email me at rich@freefrommoney.net

Thanks to a generous refund from Uncle Sam and the debt snowball, my wife and I have paid off our next major debt. At the beginning of the year the car loan had a balance of almost $6,000 and our goal was to have it paid off by August. So paying it off in March is awesome. It now looks like having my personal credit card paid off by the end of the year should be completely doable, assuming nothing major happens in our financial life (knock on wood!)

Getting rid of this debt really makes me a believer in Dave Ramsey’s debt snowball method. Not having to make a car payment anymore is a huge motivator to keep going, and a sign that we’re doing things right. We will now be putting over $1k a month on the credit cards, so even with its high balance and higher interest rate there will be a noticeable change in the balance every month. I am looking forward to watching the rest of our debt melt away over the next year. Now I need to get back to tracking our net worth to see where we’re at.

This post is part of the financial basics series

When you have multiple credit cards, car payments, student loans, and other consumer debt it’s easy to begin to feel overwhelmed by the payments.

If you want to take control of your debt, it is important that you have a method and a plan to pay your debts off. A plan will give you control and put you one step closer to financial freedom.

So how does it work?

The first thing you will need to do is make a list of all your debts, including the balance and the minimum payment due each month. Next you will need to figure out your budget and determine the maximum amount of money you can pay towards your debt each month. Ideally you can pay more than the total minimum payments, but it may be that the most you can pay is the minimum amount due. This is fine. If the total amount you can pay is less than the minimum payment you need to go back and rebudget, and figure out where you can cut costs elsewhere so you can make your payments.

Now that you have a budget, you will need to decide which debt to pay off first. There are multiple ways to choose which order you should pay your debts off, but there are three main schools of thought on which debt payoff order is best, each with it’s own pros and cons which you should consider.

1. Payoff the lowest balance debts first (the debt snowball)

This is the method advocated by Dave Ramsey, and is the method my wife and I are using to payoff our debts. Using this method you will put any extra money towards the debt with the lowest balance, paying extra on it every month until it is paid off. When that one is knocked out you will put all of the money you were paying on the first debt and add it to the minimum payment of the next lowest balance debt, paying extra on it until it’s paid off. You will keep doing this until you have paid off the last debt. By the time you get to the debt with the largest balance you should be able to put a massive amount of money towards it every month (hence the name debt snowball), since the rest of your debt will be gone. While it may not actually be the quickest method to paying off your debt, it will feel like things are in motion since you every few months you can potentially get rid of another debt payment, which means one less bill in the mailbox.

The downside is that, mathematically, it is the least efficient method if your highest balance debts are also the ones with the highest interest rates, and over time you will end up paying the most amount of interest. My wife and I actually faced this dilemma, since our credit cards have both higher interest rates and higher balances compared to our car loan and student loans. Still, the excitement for us of paying off our car is worth the higher costs.

2. Payoff the highest interest rate debts first

With this method, endorsed by Suze Orman, you will order your debts from the highest interest rate to the lowest interest rate, and begin to pay them off in that order. Again, once a debt is paid off you will put that money towards paying down the next debt. As I said before, if you are looking for the method to pay the least amount of interest over time, and the method to pay off all debt in the absolute quickest fashion, this is the one to use.

The only downside to this method is a psychological one. If your highest interest rate debts also have high balances, it might take a long time to pay them off. It may begin to feel like you’re not getting anywhere with your goals, and you may find yourself in a rut. And if this leads to a breakdown in discipline, you might go off on a spending spree and quit altogether. And that, of course, would not be good.

3. Payoff debts according to their ‘DOLP’ number.

DOLP (Dead On Last Payment) is a trademarked term used by David Bach, author of The Automatic Millionaire. This system actually works out to be a hybrid of the previous two methods. To use this method you will need to find the DOLP number for each debt, calculated as the total balance divided by the minimum monthly payment due. Once you have all of the DOLP numbers calculated, you will order them from lowest number to the highest. The lowest DOLP debt will be paid of first, and the highest last. If you have no extra money to pay down your debt every month you are actually using this method by default, since you will pay off whatever debt is receiving the highest % of its balance first.

Let’s look a little deeper into the DOLP method. There are two ways a debt could have a low DOLP number. The first is if the minimum payment due is large relative to its balance. For example, consider two credit cards with the same balance, but with different interest rates. The credit card with the higher interest rate will have a higher minimum payment, and thus a lower DOLP number, and should be paid off first. The other factor leading to a high DOLP number is a relatively low balance. An auto loan payment for instance, is a fixed amount every month. As the balance gets lower, the DOLP number goes down, meaning you will pay it off sooner. Getting rid of low balance debts means more money freed up to pay down other debts, and one less bill in the mail every month to worry about.

In short, using the DOLP method prioritizes higher interest rate debts and lower balance debts. Of course using this method doesn’t guarantee that you will pay off the highest interest rate debts first. You can still end up paying more interest over time than simply paying off debts in order of the highest interest rates.

Attack your debt

Once you have decided what order you will pay your debt off, the next step is to start doing it. Being consistent every month is the hardest part, especially if you figure out that it is going to take years to pay everything off (like I did). You may think to yourself “What’s the point?” I know this feeling well, but if you don’t do it now, when? Unfortunately your debt is not going to magically disappear. The only way to overcome it is to attack it with every bit of money and effort that you can. Keep picturing how great it will be to not have anymore debt. And think about the money you will have to save every month once that debt is out of the way.

It won’t be an easy road, especially if you have a lot of debt. But stick with it and you will be debt free before you know it.

Have you ever noticed that when you look back on products you once thought were awesome, many of them seem not that great anymore? Often times something you covet (or something you bought) is replaced by something better. It’s not that what was there before is bad, it’s just that by comparison it’s not as great. Computers are a prime example, computing power becomes much cheaper every year. But this is true for many things. For cars, a new model with drastically different features or a redesigned engine with more power can quickly change your opinion of the car you recently loved.

I really started to consider this comparison effect today while reading the tech news. I have been thinking about buying a new digital camera for a few months now, and am slowly saving up enough to purchase a fancy new dSLR. I had been eyeing the Nikon D40, Nikon’s entry level dSLR camera which has steadily been coming down in price. But today I read that Nikon would be releasing the D60 as the new entry level camera. This should be great news for anyone looking to buy a D40, as the price will likely come down. But now I find myself thinking about buying the new, and likely more expensive, D60 instead. It’s not that I don’t like the D40 anymore, the D60 just seems to have enough features to justify its higher price.

But this reasoning can quickly and easily lead to an escalation of costs. The next camera in the lineup is only a few hundred higher and has useful features too, so why not buy that one instead? But what stop there when I could spend just a little bit more and get the much better Nikon D200? Or the D300? Many people can see the faulty line of reasoning here, since you simply set a budget and buy what fits. But when you have a huge credit line, it’s easy for that budget line to creep higher and higher.

This is where savings and buying with cash come in. By saving the money to buy the camera I will buy only as much as I can actually afford, instead of justifying a bigger purchase with credit. This is almost always a good plan for buying anything, from a new car (or a used car) to electronics to clothes.

So how do you manage purchasing new tech gadgets? Is it always cheaper to stay one upgrade cycle behind? Or is it ever worth buying the latest and greatest? And how often is it appropriate to upgrade to something better?

A Wall Street Journal blogger mentions that bad math can lead to costly money mistakes. The mistake is not taking into account the effects of compound interest. 

Compound interest is one of the most powerful ways in which saving and investing can help you reach financial independence. In short, compound interest is interest on interest. Compound interest is when your money works for you, instead of you working for money.Here’s an example of how compound interest works. Suppose you have a $1000 emergency fund in an ING high-yield savings account earning 4% interest annually. After one year you would earn $40 in interest. Easy right? Now suppose you leave it in there for another year, how much interest would your account earn? If you said $41.60 you are correct. You see, the $40 that you earned last year was working for you, and enabled you to gain an additional $1.60. I know it doesn’t sound like much, but suppose you paid off all of your debt and managed to save $100,000. Now your interest will net you $160. And that’s only the second year. Every year you keep that money in there, the amount of compound interest will go up. Also keep in mind that most banks compound interest daily, so you will earn slightly more interest than simple annual interest.

Of course compound interest can work in reverse. If you don’t pay your interest charges in full that amount will be tacked onto the balance, which will lead to higher interest charges and corresponding higher payments. Unfortunately nasty products like negative amortization mortgages make it easy to pay reduced payments and allow interest to accumulate on your loan. Never take one of these loans out, it’s only good for one person, and that’s the one getting paid the extra interest.

One of my biggest questions is why topics like this are not covered more in depth during high school? I know trigonometry is important, as is reading Beowulf and learning geography. But this is practical knowledge that kids will need to know for the rest of their lives. How much more might new workers save for retirement if they knew that their money would make them even more money with no additional work? The author of the study remarks that people don’t ask tough questions because they don’t want to seem naive. I would argue that many people have no clue about how compound interest works and wouldn’t even think to ask about it. But if you’re reading this you now know a little bit more about what compound interest is and how it works. 

If you’re interested in the math behind compound interest, check out the Wikipedia entry. Or, if you want a simple calculator to give you an idea of how much an initial lump sum can grow, take a look at MoneyChimp.com’s Compound Interest Calculator. And as always, if you have any questions feel free to contact me at my email Rich@FreeFromMoney.net.

“Those who cannot learn from history are doomed to repeat it”

Before we can really begin to plan where we’re going, I think it’s important to reflect on where we came from.  I have been working on this post for about a week now, and while I would love to tell you a long elaborate story about how my wife and I got into so much debt, the truth is neither of us really knows exactly where the money went.  I think most people who are in debt feel the same way.  Except for a few expensive things that we’ve bought like a plasma TV and an expensive mattress, it’s the nickel and dimes of life that are thrown on the credit card that add up over time.  It’s those nickels and dimes that turn into thousands of dollars when only the minimum payments  are made on the balance every month. 

So instead of a giving you a long, drawn out story to read, which probably wouldn’t be that interesting anyways, I thought I would list a few of the pivotal points in the past few years that got us into the debt we’re in now. 

 The beginning

My wife and I haven’t always been in debt.  After high school I spent four years in the Marine Corps, and was pretty conservative with money, mostly because I never had any.  At the time I only had a single credit card with a low $1,000 limit, and I almost never carried a balance.  My wife went through school with a small shopping addiction, but nothing too crazy.  She graduated school with one fairly low student loan. 

Going back to college is when my own debt really started to build up.  I received money from the GI Bill every month, but that was just enough to pay rent and buy food.  This was also around the time my wife and I started dating, so of course going out on dates was a regular thing then too.  Dating and fixed income don’t really mix too well, and I still spent money like I was receiving a monthly salary.  

Buying a new car

About a year after my wife started her first job, her 1990 Honda Civic called it quits.  But not in a cheap fashion, instead it would randomly die on the freeway, and then start up again as she tried to coast to the side of the road, giving everyone in the car a good scare.  The mechanics couldn’t determine what caused the problem, so our only choice was to pay a few hundred dollars at a time to try and fix what may or may not have been the problem.  Instead she decided it was best to buy a new car.  But not just any car, a car that cost about 100% of her annual salary (the car we’re currently working to pay off).  She financed it for 6 years, which reduced the payments, but meant she would end up paying more in interest over the loan’s life.  Being able to afford such an expensive car meant paying everyday expenses with the credit cards, always with the good intention to pay them off at the end of the month.  This is when my wife’s debt really began to add up.  

Hitting the tipping point

I would guess that near the peak of our debt, my wife and I had over $40,000 in debt, which included credit cards, an auto loan, and student loans.  The sad part is that other than a few big luxury items we shouldn’t have bought, we really don’t have much to show for all of that spending.   We used our credit cards the way you would use a debit card for every day purchases.  It was the little things that really added up - $60 to eat out one night, $60 on groceries another.  We bought nice clothes to look good for work, after all if you want to get promoted you should dress the part. We didn’t live an extravagant life, but we didn’t live cheaply either.  Shopping was a popular past time for both of us.  She frequented the malls, while I regularly went to the bookstores and electronics stores.

The tipping point for us was our wedding this past June.  We didn’t have a choice about starting our new married life together in debt or not, but we did have the choice about which direction we were going to go.  We have decided to take the road to freedom from our debt.  And so now, a few months after the wedding, is where you enter the story and we begin our journey together. 

Small Victories

Even though our current debt situation is less than ideal, we like to look back at the good choices we made in the past, choices that would have qualified as extremely dumb moves in this story. 

The biggest decision we’re glad we made was to not buy a condo in San Diego, where both of us went to school.  For one it would have been a terrible financial decision.  We would have bought near the peak and surely would have been upside down now that the housing market has begun to plummet.  Making the monthly payments would have been tough, and it’s likely we would have continued to put living expenses like groceries on our credit cards.  Add to that the interest adjustment we would have been facing, and our financial picture could have been looking very different right now.

Buying the condo would also have prevented us from moving to the Bay Area this past year, a move that has brought an enormous amount of happiness to our lives.  Both of our families live up here, as well as many of our long time friends.  We both agreed that we feel more at home here than we ever did living in San Diego. 

Another good decision was not buying another new car this year.  I totaled my car almost 12 months ago, and almost bought a new Honda Pilot.  That choice would have put our debt levels up another $30,000.  It also would have reduced the extra money we have available monthly to pay down existing debt.  Factoring in gas, insurance, and maintenance, and we would probably still be making minimum payments on all of our debt, if we could have made them at all. 

Where we’re at now

After the wedding we worked hard to pay off our joint credit card.  This card had both the lowest balance and the highest interest rate.  We paid that off at the end of November, and next up is the car.  We will continue to use the debt snowball method to pay off our credit cards and student loans until we are completely debt free.  It’s going to take a few years, but our long-term goal is to be debt free by 2010. 

 You can take a look at a past post I wrote about fulfilling the requirements to get out of debt to get a better idea of what we’re doing to work towards our goals.  

I hope if you’ve read this far you’ll stick around until then to see if the dream of becoming debt free becomes a reality.  You can subscribe to the FreeFromMoney.net feed, found at the top right corner of the page, either through RSS or email.

After getting all of our financial statements in order, I made the first calculation of our total net worth (roughly calculated as assets – liabilities). What followed was not pretty. My Wife and I know how much debt we have, yet seeing the number totaled up and written down was a shock. I will not put numbers up here, at least not yet. I will, however, keep track of our progress on a monthly basis to see how we are coming along. It will be interesting to see how much of a change occurs month to month.

What do we plan on doing from here out?

The biggest drag is obviously our debt level. Since our wedding in June we have been using the debt-snowball method to pay off our debts. The first credit card debt was knocked out at the end of November, which felt great. Next up is the car, which we aim to have paid off in July, a full year earlier than the maturity date. When that’s out of the way it will really begin to feel like we’re making a dent in our debt levels.

On the other side of the net worth equation are our assets. Most of our money is in 401(k) retirement accounts, with a small additional amount in an emergency fund. We will both continue to take advantage of our 401(k) accounts, and will continue to fund the emergency account. I anticipate that by July, when we pay the car off, our assets should outweigh our debt and our net worth will turn positive (a great thing even if it is only a few dollars!)