Debt Reduction

One of the things that people struggling to get out of debt and start wealth building have problems with is the use of credit cards. Frequently, credit cards are the reason people start getting into debt problems, and they can certainly exacerbate the situation.

You hear the same story over and over, someone will either work to pay off credit card debt, or take out a home-equity or 401k loan, only to start charging things again and building the balances on their high-interest credit cards again. Certainly, one can take measures to prevent this, by cutting up your cards, freezing them in a block of ice, etc. Part of the reason a lot of people, and I include myself in the number, fall back into their bad habits with credit card usage is a lack of an honest assessment of their ability to manage credit card usage in a responsible manner.

To make matters worse, there are certain benefits to credit card usage that many people find enticing. Cash back rewards cards or zero balance transfers give us the promise of “free” or “fast” money, with little or no effort on the part of the consumer.  But they are not without risks, especially for people who have had credit card problems in the past.  Part of the reason I am now digging myself out of appx. $10k in credit card debt is because, I believe, that I am in a “high risk” category. I have always had a problem with running up credit card bills for what I considered important stuff or “emergencies”. I am sure you can probably guess, most of these things were neither really important or real emergencies.

 However, I have always paid my credit card bills on time, and eventually in full, only to run them back up again.  I think that because I always paid my bills I felt like I was managing my credit cards, when in reality they were managing me. It has only been the last 6 months or so, when I came to the realization that I would never build real wealth by continuing along the same path, that I realized I even had a problem.  For me, it will probably be a long time before I will use credit cards on a regular basis again or get back into the “rewards” game.  I do feel like I would be responsible now, as I am not 100% credit card free anyway, but I don’t really fully trust myself.  I do still use them on occasion, but mostly for online purchases where I do not want to use my debit card, or for gas. I try to pay these off even more frequently than monthly. But I also have now built up an emergency fund to take care of real emergencies and no longer will rely on a credit card to bail myself out.

When you realize that your lack of discipline with credit cards is what likely got you into financial trouble in the first place, and don’t blame it on circumstances or bad luck, you then need to make a decision on whether you should really be using them at all.  Certainly, by stopping credit card usage for a length of time, one can begin to make strides on the road to becoming “debt free”.

By examining and determining your credit card usage “risk” potential, you can probably determine if you really should be jumping back into the world of credit card usage, balance transfers, or cash back rewards. Certainly, while many people are more than capable of using a credit card wisely and within reason, and can make money off of them, for others, frequently, the “rewards” are not worth the risk.

What’s the value of a dollar these days? Less than it was a couple of years ago, I imagine.  But what I am talking about here is the value of a dollar not due to inflationary effects, but rather on where that dollar is being utilized– and how much it really costs you. 

Let’s first look at paying off debt. For example, say you have $1.00 in credit card debt at 20% interest.  In order to pay off that debt you have to earn money, pay taxes on your earnings, and then pay off the debt. For the sake of simplicity, let’s say you are taxed at a 20% rate. You will have to earn $1.25 to pay off that $1.00. ($1.25 x 0.8 =$1.00). So to pay off that one dollar now, you have to earn $1.25.  Now suppose you put off paying that $1.00 for one year.  At 20% interest you owe, one year later, $1.20.  But to pay off that $1.20, you will have to earn $1.50 ($1.50 x .8= $1.20) one year from now to pay it off.

Now let’s look at building wealth.  Suppose you put $1.00 into your 401k account.  Since you won’t pay taxes on your contribution, that $1.00 only costs you $0.83 ($0.83  x 1.2 =$1.00) from your take home pay. So if you are building wealth with pre-tax dollars instead of pay off debt with post-tax dollars,  it costs you 66% less to invest $1.00 than to pay $1.00 in debt ($0.83/$1.25 =66%). If you want $1.00 a year from now, it costs you even less, depending on what interest rate you receive over the course of the year. Let’s assume 7%. You only need to decrease your spending by $0.77 now to have $1.00 in one year ($0.77 x 1.2 x 1.07 = $1.00). So creating $1.00 one year in the future only costs you $0.77 now.  If you delay paying off debt in the above example one year, it will cost you $1.50, or almost double what it takes to create $1.00.  If you were to throw in an employer match to your 401k contribution, you are talking about an even larger difference. 

(Now, I know I have not considered taxes when the 401k money comes out sometime in the future, but this example is to illustrate the difference in the price of debt (high) vs. investing, particularly over time. Even if you were to invest in a Roth IRA , to get $1.00 in a year at 7% would cost you $0.93 now, and be tax free, vs. the $1.50 for the $1.00 in debt if you wait a year to pay it off.)

These numbers show how much more it costs you to carry high interest debt and how it can actually cost less (to your take home pay) to invest, and should motivate everyone to pay off debt as quickly as possible, particularly non-deductible, high-interest debt, and begin investing. A great place to start is with pre-tax savings, to minimize the effect on your take home pay, certainly up to the employer match in a 401k if your employer offers one.

America Saves, a nationwide campaign to help Americans save, reduce debt, and build wealth, is celebrating “America Saves” Week from February 24th through March 2nd.  Sign up for their monthly newsletter, and browse around the site for tips.

The Website has resources and tips such as the following:

Save for Auto Purchases, Save for Emergencies, Savings and Investments, Save for a Home, and Get Out of Debt.

 Visit their Savings Tips section for a variety of money savings tips.

They also have specific campaigns, such as Military Saves, Youth Saves, Hispanic America Saves, and Black America Saves.

Campaigns by organizations like “America Saves” are great for introducing people who are lacking in personal finance awareness to understand the concepts invloved, especially teenagers and young adults, but they frequently contain information beneficial for everyone.  I would recommend that you check it out and send a link to the website to anyone you think might benefit.

Sometimes, on the road to becoming debt free, or increasing your wealth, you hit a “wall”. Maybe you work late a few nights in a row, so you get too tired to plan out your meals and cook and end up eating out. Or you forget to pay bills and incur late fees, or have an unexpected expense which wipes out most of your savings. Or maybe you don’t see the growth in your savings or investing that you would like to see. You lose faith and are soon getting back to your old ways and habits.

How do you get back on track?

One way which has been useful to me, is to do something extreme. You have to take “extreme measures” to give yourself a boost and stop yourself falling back into bad habits.

Burn Bridges:
Eliminate your escape routes. Do something that limits your options.
Pay all of your bills as soon as you receive them, and put the rest towards debt reduction.  For example, say you are 10 days from payday, you have $1000 in your checking account, and you estimate you will need $500 for bills and food for the next 10 days. Well, take $499 and put it towards your credit card debt now, so you have you are left with $501 with $500 in expenses over the next 10 days. You have no choice but to live within your means with only a $1.00 cushion.

Do Something Extreme:
Don’t just drop your cable subscription, or Netflix. That may not be extreme enough. Drop your cable subscription and sell your television! (Now obviously, if you are married and have children, etc., you need to make sure they are on board!) Now, the TV is just an example, it could be anything, but you get the idea.

Pull an All-Nighter:
If you are falling behind on your bills, stay up late one night and take care of them. Or write out a plan for your debt reduction, step by step.

Sell one of your “prized” possessions:
This could be a collection, an autographed football, your motorcycle you only ride on weekends, or maybe just “stuff” you have laying around the house. Sell them to generate additional cash to assist you getting back on track.

Challenge Yourself with Spending:
Set an extremely low amount (whatever that may be for you), say $30 if you are single (whatever is a low amount for you), take it to the grocery store, and buy all of your grocery items for every carefully planned meal for a week with that money.

Challenge yourself to earn additional income or generate additional cash, such as $500 over the next 30 days.

One good thing about this strategy is that it forces you to come to terms with how badly you want to reach your goal. If you are willing to take extreme measures to reach your goals as quickly as possible, then your goals are obtainable. If you decide the sacrifices are too great to reach, you may need to rethink your goals and how quickly you want to achieve them.

• Which is the better high yield savings account, ING Direct or Emigrant Direct?
• Should I pay my highest interest credit card off first, or the one with the lowest balance?
• Should I open a Traditional IRA or a Roth IRA?
• Should i use Sharebuilder, Zecco, Vanguard, or someone else for my IRA or brokerage account?
• Which “rewards” credit card is the best and which one should I use?
• Quicken or Microsoft Money?
• Should I prepay my mortgage or invest any extra money I have?

While all of these questions, and ones like them, do have merit, don’t waste a lot of time worrying about whether you made the right decision regarding these types of decisions. The worst thing you can do is to put it off or be afraid to pull the trigger. I know. I have an old 401k I have been meaning to roll over for over a year. I put it off, and then forgot about it for a while. With any decision, financial or otherwise, pick which one you feel most comfortable with after your analysis, do it, and move on to the next item.

The important thing is to DO IT NOW. Don’t stand on the sidelines. Jump on in.

“In any moment of decision the best thing you can do is the right thing, the next best thing is the wrong thing, and the worst thing you can do is nothing.”-Theodore Roosevelt

Trent over at the Simple Dollar  had a post yesterday in which he stated the old adage “the rich get richer and the poor get poorer” is a myth, and received many comments in disagreement. It even prompted a follow–up post regarding ways people can improve their situation, regardless of where they are now. A sentence from his follow-up post which really caught my attention was as follows:

“You don’t need anything except a desire to accomplish more than you’re accomplishing and the work ethic to do something.”

It really got me thinking, especially regarding personal finances, that in order to dig yourself out of a hole, e.g., get out of debt, no matter how deep it may be; you really, really have to have a desire to change your situation. I don’t mean just “wishing” you weren’t in debt, or had more money. You have to have to develop a burning desire and then act on that desire. You have to focus all available time, energy and other resources towards getting where you want to be, whether it is getting out of debt, becoming wealthy, or any other goal. One of the reasons I started this blog, thinkyourwaytowealth.com, was to keep myself focused on getting out of debt and growing wealthy.

In order to accomplish any goal, you have to:

• Decide what you want.

• Decide how badly you want it, i.e., develop a burning desire, and then

• Focus your time and energy towards accomplishing your goal until you achieve it.

 Note, I didn’t say prepare and file your taxes. But, I have already prepared and filed my taxes. Why? Well, I filed because I am getting a refund.  Which I really don’t like - because I  gave the government an interest-free loan over the last year.  But I like to do a “dry run” of my tax preparation, to determine where I stand, as early as possible, when I have received all of the financial documents from my employer (W-2), savings accounts (1099’s), etc. I like to do this early, for two reasons:

1.) If I am getting a refund, I file right away, because I like to get it back from Uncle Sam as quickly as possible, instead of waiting till April 15th,  and put it to work for me, instead of the government.  It also gives me an  opportunity to decrease my withholdings for this year now, so I don’t lend Uncle Sam as much money this year.

2.) If I owe taxes, it allows me to figure out what I owe now.  If the amount is significant, it allows me to budget the money over the next 2 1/2 months, so I am not surprised a couple of days before the April 15th deadline. Also, it allow me to increase my withholdings (assuming I  am going to be in a similar financial situation next year) if necessary, to minimize the amount of my tax liability next year.

As for me, I am going to take my refund and pay down debt. If you are looking for ideas on what to do with your refund, check out Single Guy Money’s 4 Part series, Suggestions for your tax refund.