Basics - Free Up Your income

In order to maximize our debt paying potential we need to do a few things:

1) Change your tax rate.  If you are getting an income tax refund every year then you are overpaying on taxes.  While it's nice to get a big check once a year, you are essentially giving the government a loan at 0% interest.  To make matters worse, if you also have debt then are paying someone else interest to borrow at the same time.   

2) Reduce your 401k contribution until your unsecured debts are paid.  Yes I said that right, you must reduce your contribution now to build wealth later.  Why?  Your earnings just don't offset what your paying out.  The only way debt while building wealth ever makes sense is in the case of a very low interest rate on an appreciating asset such as land.  Now I know some of you are gonna argue with me on this stating that because of compounded interest you will never catch up. While that is true if you do it for 10 years, the goal is to be out of debt as soon as possible. So if you are currently contributing 5% and can barely pay your bills. Drop the 5% for 18 months or so and then once out of debt, reinstate the 5% and anything else you can afford on top of that. Most of us will go from 5% to 18% and quickly you will be building wealth much faster than you would have if you kept going on the way you were.  

3) Stop overpaying on all accounts except for one.  Are you paying an extra $20 a month on 3 credit cards?  Or rounding up your house payment each month?  Stop!  Take all of this extra and put it on your debt reduction plan (snowball).

4) Ditch any extra services not needed such as Netflix, Cell Phone insurance, Magazine subscriptions, etc.

Basics - Your Debt Reduction Plan - Snowball, Avalanche or frustration?

When it comes to your debt reduction plan there are numerous options but I will cover the most talked about ones in detail.  Regardless of which you choose, you need to get a whiteboard, scrap paper or spreadsheet and to compile a list of all debts.  We want to know your current balance, interest rate, available credit, and of course when it's due each month.  All of this is available on your monthly statement.  

1) The old tried and true pay the highest interest first method also called the avalanche.  This is the method Suze Orman advocates regularly.  Basically look at your list and whichever one has the highest interest rate gets paid off first then the next, right down the line.

2) Debt Snowball is Dave Ramsey's method.  Take a look at your list and find the one with the lowest balance, attack that one first.  This method may not make sense on your calculator but it does provide stress relief.  If you are currently opening 10 credit card bills in a month and can within a few months reduce that to 6, you have cut 40% of the worry.

3) The frustration method isn't really a method at all it's simply kicking the bully out of your life.  Take a look at your list, which one causes you the most anger, frustration or heartache?  Choose that one first.

4) Debt to income makes no sense to me.  This is essentially choosing the one that's the closest to its limit.  While this is important to your FICO score, you should not be worried about that while in debt.

So which one is best?  Much like a diet, the most effective one is the one you stick with long term.  I personally started with the debt snowball until I got down to the large balances and then switched to highest interest first.  In short, do what works for you.

Basics - What's an Emergency Fund?

Ask Dave Ramsey or Suze Orman and you will find different opinions on the quantity required in your emergency fund but both agree that you need one. So just what is it? Essentially it's accessible cash. This is money set aside not for wealth building but for things that come up. This is not spending money and should be kept in a separate account just to prevent you from overspending. This money is used for things that you do not have enough cash flow in your spending plan to cover. Good examples are insurance deductibles, furnace repairs, cars breaking down, etc. These things do happen but they are really hard to plan for and to someone who swims in credit card debt they are a constant source of worry. Those with an emergency fund do not have to worry as it's always there just in case.

Now let me set one thing straight. Some say that you need six months of household income while others eight months or even a year. I personally agree with all of those but you don't have the money to build this fund while still paying on debt. I happen to agree with Ramsey here in that his first step is to set aside $1000 dollars and then put every penny you have into paying down debt. Later you build up that $1000 into month’s worth of income. What I disagree with is that he calls both of these funds, your emergency fund interchangeably. I personally believe that the $1000 is you’re just in case fund and the several months' fund are for a true emergency. I personally chose to keep that $1000 in my regular bank's savings account so that I have readily available access. The true emergency fund is kept in an online bank which I can write a check against or use a debit card. I do NOT carry either of those around with me. Any true emergency can be easily covered with this account by stopping at home. Even if your car's transmission goes out, you can probably give them $500 down and pay the balance later, same goes for medical emergencies, etc.

So let me be very clear here, this does not mean that the just in case $1000 is not for emergencies. You will first try to cover the expense with monthly cash flow by robbing other portions of the monthly spending plan. Next if the emergency is too large to cover with cash flow, then utilize the $1000 and ultimately then into the large emergency fund. Beginning with your next paycheck, you would then begin refilling the $1000 bucket before paying down additional debt. To you Ramsey fans, the Just in Case $1000 is referred to as Baby Step One (or BS1). Think of it like this: Cash flow, then $1k, then Emergency Fund. One other thing to always keep in mind is to tell the business that you will be paying cash and ask if they offer a payment plan or discount based on that.

Basics - Establish a Spending Plan

Say the word budget and most people get scared. They immediately are overwhelmed with feelings of constriction. While this is simply not true, I prefer to think of mine as a spending plan.  It's truly about telling your money where to go instead of wondering where it went.  

Each month before I get paid I make a plan for all the bills that are due before the next paycheck and filling my buckets.  What are buckets?  These are also known as envelopes or sinking funds.  Think of it this way:  Every year I buy a season pass to the local amusement park and each year I would charge  the expense on my credit card as if it was unexpected.  Today, I  set aside a portion each month.  When it's time to pay, I never even miss it.  This same type of process is done for everything from toiletries to my two kittens' vet care.

While all of this sounds hard to do, it's simple after the first month and it provides stress relief because the money is already spent filling the buckets before you actually spend it physically.  The only part of this that's up for debate is if a bucket continues to have excess in it at the end of the month then what do you do?  You have a few options:  1) reduce the amount put in monthly 2) blow it 3) do not put anything in for one month and redirect that money elsewhere 4) continue to add for a larger event.  I do a combination of those things depending on the bucket.  The kitties' bucket continues to grow as you never know what'll come up.  The restaurant bucket I blow by taking my wife out for a special night when we have extra.  The clothing budget has a cap.  Once it's reached I redirect the money elsewhere until we spend some out of the bucket.