Tackling Debt

Getting your finances on track: budgeting

If you’re “underwater” financially, or really don’t know where to start, you’ll probably want to create and follow a budget for a while. Think of it like a pair of training wheels while you’re trying to learn to ride this bike called “money management.” Let’s take a hypothetical friend called Fred. Fred’s based in North Carolina, makes $70K annually, and often feels like he’s living paycheck to paycheck – hardly any money left in his bank each month.

$60,000 Annual Gross Income
$44,352 Annual Take Home Pay (after taxes)
$3,696 Monthly Take Home Pay (annual income / 12 months)

Monthly Expenses:
$900 Rent
$100 electric/water/gas
$150 Student Loan 1 (payment on $15K balance at 5% interest)
$200 Student Loan 2 (payment on $5K balance at 4% interest)
$100 Credit Card 1 (minimum payment on $2K balance at 23% APR)
$200 Credit Card 2 (payment on $5K balance at 18% APR)
$500 Food
$200 Entertainment
$50 Cell Phone bill
$170 Cable Internet/TV
$400 Car lease
$90 Car Insurance
$150 Car Gas
$200 Miscellaneous/Discretionary

Well, Fred’s not imagining things. He’s spending a total of $3,410 of his $3,696 take home pay, so when he sees his bank account go up by a paltry $286 each month it might be a bit depressing. How would he handle an emergency? What if his car broke down? What about a vacation? This unfortunately isn’t too far removed from the average American worker’s financial situation.

Creating this budget was a good first step in understanding where exactly Fred’s paycheck is going each month. There are some easy fixes to give Fred some breathing room, but there’s also going to need to be a shift in mindset if he’s going to be able to have some level of control over his finances.

Rather than focus on things he can’t easily change (like perhaps not leasing the brand new car that he went with), I’ll try to go over some changes we can make today. First up: Fred is paying out a lot of money in interest payments, but we’ll come back to that in a moment.

Fred needs to free up a bit of cash to take care of these debts that have his finances crippled at the moment. There’s not much he can easily do about the car lease at this point, and his rent and electric/gas/water bill are pretty decent for the area. But after some discussion, Fred agrees to stop eating out for every lunch/dining out often at expensive restaurants, and feels he can shave that food budget down to ~$200 by doing more grocery shopping and brown bagging some lunches. It was also discovered that the amount spent on entertainment is over-sized (going out for drinks with buddies often / every weekend) and could be cut back by ~$100. Finally, the cable/TV bill seems a little high. Turns out Fred doesn’t actually watch much content on the TV: he’s able to live without the cable TV package in favor of Netflix / Hulu / Amazon Prime video, or some other internet TV service, but needs the cable provider for internet access. That’s great! The internet-only package is about $40/month but he’ll be paying ~$10/month for Netflix.

Not a bad first pass. Fred was able to shave from his expense budget:
$300 in excess food expenses
$100 in excess entertainment expenses
$130 from the “gold-tier” cable package he’ll hardly miss
-$10 for his newly acquired Netflix subscription to supplement his loss of cable TV channels

That’s an extra $520/month in spending power Fred now has. Ideally, Fred should first build up a savings about 6 months of living expenses. He could build up more (up to 12 months) if he feels like he needs additional security, or has a family/dependents. Alternatively, if he’s single (which is what his budget/expenses are modeled after), and he is feeling very confident about the job market and his ability to find work if he suddenly lost his job, he could stop for now at 3 months to begin the next phase of wrangling his expenses.

Pay down the most “expensive” debts first (the snowball strategy)

There’s a few different ways to tackle debt, but first: “why all the fuss? My service provider says I only need to pay this ‘minimum balance’ of $50 or so. Isn’t that way better than (unnecessarily) paying more?” Well sure, we’d all like to pay less for services if we could, but what’s not so obvious is how the interest your provider is charging you works. Most debts have an interest rate attached to them. Each payment period, the provider is calculating interest on your remaining balance and adding it to the remaining balance that you need to still pay off.

Let’s take an example:
Fred owes $2000 on his first credit card. By paying $100 each month, he won’t have paid it off after 20 months. With that insane 23% credit card interest rate being factored in each monthly statement, he’ll actually be paying off a total of $2600 over 26 months. That’s the power of interest – Fred’ll lose an extra $600 over what he originally charged to the card for having the credit card company effectively “loan” him that $2000. Fred may infact have additional expenses to put on his cards which will only prolong the period until he’s debt free. It’s actually possible to stay in debt forever by naively continuing to pay less than the interest plus new charges applied to the card each month!

One school of thought is to pay down your debts in order of smallest to largest thus helping you arrive at a situation of having less “debts,” which some folk find to be psychologically beneficial and freeing. The method I personally prefer involves paying down your “most expensive debts” – basically: the ones with the highest interest rates. Those are the ones “costing” you the most each month to keep around. For Fred, after he’s established an emergency fund, he should have the original $286 of spare cash and the $520 he managed to shake out of his budget. By paying the minimums on his other debts, and “redirecting” that cash towards his most expensive debt, he could wind up with something like this:

$75 Student Loan 1 (originally $150 – $75 redirected)
$20 Student Loan 2 (originally $200 – $180 redirected)
$1311 Credit Card 1 (originally $100 … + $75 + $180 + $150 + $286 + $520)
$50 Credit Card 2 (originally $200 – $150 redirected)

Instead of taking 26 months to pay off Credit Card 1, Fred could buckle down and pay off that $2000 balance in $2K / $1311  = ~ 2 months, and then direct the money that went towards Credit Card 1 to Credit Card 2 (his next most “expensive” debt) and get that paid off in $5000 balance / ($1311 redirect + $50 already paying) = ~ 4 months.

Rinse and repeat: if the APY on his car lease is higher than the rate on his student loans, and doesn’t have much in the way early re-payment fees, he could tackle that next. Following this recipe, Fred could most definitely be rid of all of his debt in 2 or 3 years, and should switch to paying off his credit cards in full each month to never have to worry about interest payments on them again.

Of course Fred will have some additional expenses that he might need to push onto his credit cards over the months, but the fact still remains: that by controlling your expenses, and being mindful of saving more than you’re spending, you can rid yourself of crippling debt and set yourself up to begin building a nest egg to put towards a brighter future.

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