Riddled with Debt?
A Simple Three-Step Plan for Annihilating Debt.
A Sobering Fact
In July of 2009, CNNMoney.com reported that total consumer debt was $2.52 trillion dollars. That’s about $8,400 of debt for each of us. To be clear, “consumer debt” mainly involves three sources of debt, student and auto loans, and credit cards. Other types of debt like mortgages, get counted in a different bucket. You don’t even want to know what the total debt figure is for all forms of borrowing.
And this $2.52 trillion figure is actually something of a good news story..in 2005 the total consumer debt was $2.7 trillion, so we’ve actually come down a bit (about 7%). That masks a deeper seated problem though. Even though the borrowing trend is headed down for the moment, this is based more on the poor economic conditions, and not voluntary change in behavior.
Well so be it. Either because of circumstance, or because of a longer term change in the American Psyche, we are borrowing less.
However I run into lots of people who may be borrowing less, but have no idea about how to change their habits for the long term. I hear them mulling over the “cash for clunkers” program (which I think is a bad idea), or contemplating taking a loan out for a real estate purchase to take advantage of the “bargain prices.” These individuals are not seeing the risks involved with all that debt and little savings.
So I wanted to offer a simple 3-step plan to busting up the debt. This strategy follows Dave Ramsey’s approach closely, but I have a few unique suggestions to make. So without further ado:
Step 1 For Getting Out of Debt: Establish a Simple Emergency Fund.
The first step I recommend is to establish a cash emergency fund. To make my case I’ll flash back to when my wife and I had only one income (she was going to law school). I made decent money from my employer, but I rarely balanced my checkbook. To make matters worse, both my wife and I managed to put some things on credit cards every month. We purchased on credit cards because we didn’t have enough cash left at the end of each month. Sometimes, we simply got things because we wanted it and we had the beloved plastic. Deep into the fall, early 2000s, we managed to bounce our checking account. Not only had we overdrawn, but we borrowed on the credit card at an even higher interest rate to get the account back into balance. What a mess.
We’d go through bouts of swearing off the cards, maybe even cutting up a card or two. But this strategy inevitably failed for two reasons:
1) We had not made it a habit to carry cash, to purchase items.
2) We did not have an emergency fund.
These two behaviors kept us dependent on the plastic monkey. Time and time again, we would have an “emergency,” and instead of walking out of the store and getting hard-earned cash out of the bank, we’d pull out the gray-plastic platinum card to pay for our pseudo-emergency. When a real emergency did occur, like the truck needing new brakes or the dryer going kaput, it was almost a guarantee that it would go on the card.
It wasn’t until I read about an emergency fund, and got my wife to agree to put our credit cards in a frozen block of ice (seriously), that things really started to change for us.
You might ask why — why would an emergency fund change anything? Well for starters it symbolized a committment. By putting $1,000 in an emergency fund, my wife and I were making a promise to each other, that things were going to change. We didn’t want to live with the monkey any more. It made my wife nervous and insecure; and it made me feel like a failure.
So as quick as we could possibly manage, we saved up a $1,000 cold hard cash, and put it in a bank account. This was a high-yielding money market type account, like INGDirect. The trick for us was to not make it too easily accessible (we need about 24-48 hours to get to it), nor too hard to access (like when you have emergency funds tied up in stocks or bonds). This strategy worked! I started feeling a sense of confidence flow through me. And my wife told me she felt less scared, which meant we were about to fight a lot less, even though I did not realize it.
The $1,000 had some other hidden benefits as well. It earned a little bit of interest in the money market account we chose — always nice to make compound interest work for you. In addition, it actually made me a little more confident on the job, since getting fired just seemed to be a little less scary of a concept. And ever since establishing our emergency fund, I’ve seen my income grow by leaps and bounds. Coincidence?
The biggest benefit though was it allowed us to use cash, instead of credit. Which freed us up to do Step 2.
Step 2 For Getting Out of Debt: Going for the Lowest Balance Debts First.
I have an MBA, I loved my finance, investing and accounting courses (I know, I’m a geek). What those classes never taught me though, was that personal finance is 80% behavioral, and only 20% mathematical. I have to thank Dave Ramsey for setting this matter straight. In his Debt Snowball step, he recommends listing all your debts from smallest to largest on a sheet of paper. For my wife and I, this was a bit complicated because we did not know what some of the total balances were (like her student loans). After a bit of leg work, we got the list straight though.
Assembling the our tally sheet helped. For the first time in a long time, I felt like I had a sense of knowledge about my situation, even though it was a bit dire. It still felt better than the gnawing fear and uncertainty of neglectful ignorance. We had one credit card we had forgotten to pay. Okay, we got that current. We had the means. One of our lowest balances was actually my mom. She had given us some earnest money to purchase a house, and instead of being able to pay her back when our prior house sold, we were stuck with two homes for awhile, and did not have the cash to pay her back the full amount.
Now it worked out just right for us, that we owed my parents the least amount of money, but I believe Dave would say that relatives should be paid back first regardless of the balance, because that owed money is like a poison in family relationships. So without much hesitation, we started applying all our extra money to paying off the loan my mom had given to us. In a short couple of months, we had knocked that one out.
Then we paid off the next highest balance, and then the next one, and the next one. With each balance, we could roll a the freed up extra money into paying off the next biggest balance.
I never realized how powerfully motivating this could be. I’m not saying it was easy, but knocking out these lower amounts, gave me a fresh hit of motivation, each time my enthusiasm waned. As we continued to reinforce this behavior, my wife and I were growing more confident. We were also building up our stamina to take on even bigger financial hurdles.
My wife and I were fighting less as a result of the debt snowball, and I’m convinced this saved us from financial disaster. In 2008, my job was eliminated. Because of the emergency fund, and because we had been aggressive about paying off our debts, we manage to minimize the impact. I was quickly working again, and making even more money than before, but I have to attribute some of this to just feeling more confident and secure that we weren’t destined to live in my mom’s spare bedroom, with two kids, two dogs and a rat to boot.
A final part of the debt snowball (paying off our debts, smallest balance to largest and rolling each amount into the next debt), was that we froze our credit cards in a block of ice. They remain in the block of ice to this day. We have no plans to go back to credit, ever. Our behavior change is permanent (we hope). I’m not sure why we have the cards still. Maybe just so we can tell the story.
Step 3 For Getting Out of Debt: Change the Way You Handle Your Cash.
Your money is yours. You work hard for it. You should have control over where it goes and what you use it for, yet for so many of us, it feels like we have no handle, no control, and we are not even sure where the money does go.
One of the ways you can start to change this is by doing a quickie budget. A quickie budget is where you simply take your monthly income, and on paper allocate on the income to your expenses for the month. You start first with your basic needs, food, clothing, shelter. Got keep food on the table, the lights on, and your kids will occasionally outgrow things (if you haven’t noticed). This is basic stuff — food from a store, not eating out every night. Buying clothes, not Nordstroms. Providing shelter, not two vacations, a beach rental and a houseboat.
Once you have the basic needs budgeted, you spend all the rest of the money until you reach “zero” at the bottom. If you have any extra money, you put that on your debts, and keep pursuing the debt snowball.
This simple act of planning out your money flow for the month ahead, can be transforming. And let me make a distinction. This is not simply reconciling what you spent in Quicken. That’s actually looking backwards in time, and will do very little to change your or your significant other’s behavior. Someone in your family will need to develop the muscle of planning out the month ahead on paper, so you can have an idea of where your boundaries are.
My wife and I have flirted with budgeting since we before we were even married. For a long time she kept track and paid the bills, and then we both sort of shared the responsibility (which did not work too well), and now I’m the spreadsheet nerd. That doesn’t mean I control every dollar, and I have to approve every purchase my wife makes. It just means it’s my responsibility to do the budget, and then show it to my spouse. She reviews, maybe suggests some changes, and we spit shake on it for the month. Since I’m the numbers guy, I go off and pay the bills. One of the things I learned from this process was that I we could still accomplish the goals I wanted (like paying off debts) while still allowing for a few fun things for my wife and the kids. So don’t use this process to be a tightwad if you are the bill payer in the family. Use it to have a plan, use it for you and your significant other to agree on how the month ahead should flow.
If you are single, my suggestion would still be the same, but I suggest you go and find an “accountability partner,” This is someone who functions a little bit like a spouse would. It should be someone strong enough to call you on your financial BS.
One final note under this 3rd step; we also found it helpful to carry more cash around (which we now had some, because
a) we knew where it was, and
b) we had been paying off some of our debts, hence freeing up cash flow.
We used the cash to pay for expenses like groceries, dining out, or other types of shopping. The principle in play for us was that when we spent cash, it hurt a little to part with those hard earned dollars.
That little bit of hurt, made us wiser and smarter shoppers. It also gave us negotiating power. Imagine the reaction you’d get if you offered $500 less than the asking price on a furniture set, by flashing the cash to the sales manager. When your negotiating is rewarded with a discount, my guess is your going to be feeling pretty good about yourself.
Summing Up the Benefits of Getting Out of Debt.
This part for me is incalculable. If you are a spreadsheet geek like me, then you’ll get my joke that it goes way past row 65,536 in terms of value.
But let me be a little more specific on how this simple approach can change your life. First, you get to feeling more confident. This will manifest in different ways for men and women. I’m generalizing here a little bit, but typically women will feel more secure, and less anxious about money, when you have an emergency fund, and you know where your money is going.
Men tend to feel better because we like to keep score. We like to keep score on everything we do, and money is no exception. $1,000 emergency fund? Score. Debt snowball list? 2 points. And can I forecast a date when I will be debt free? 3 points. And more cash in our wallets, so much that it hurts to sit on it and move it to our front pockets? Game over – I win.
If you add the additional benefits of not fighting as much, demonstrating healthy behaviors to your children, friends or family; then the value of these simple steps starts to really add up.
I ask you to join me in this process of become debt-free and living a little more prosper-ish. Let’s get this monkey off our backs for good.
