In a recent discussion about why I’m looking at paying off debt in the short term over investing, a reader mentioned Dave Ramsey’s book The Total Money Makeover, which basically encourages everyone to follow these seven steps to financial freedom:

1. $1,000 to start an emergency fund
2. Pay off all debt (except the home) using a debt snowball
3. 3 to 6 months of expenses in savings
4. Invest 15% of household income into Roth IRAs and pre-tax retirement
5. College funding for children
6. Pay off home early
7. Build wealth by investing

These steps were debated rather vigorously in the comments, with some people thinking that these were a great idea and others discarding them as rubbish. I thought I would give my general thoughts on them, especially as they apply to our personal situation.

First of all, in April 2006 we were at step zero on this plan. We hadn’t done any of these, a few of our bills were late, and we were feeling rather desperate. The culprit? Overspending.

Since then, we built up our $1,000 emergency fund, paid off all of our debts except our student loans and our mortgage, moved into a house, got four months’ worth of living expenses built up, started putting more than 15% into our retirement plans, and started a well-funded 529 for both of our kids. In other words, we completed steps one, three, four, and five of Dave’s plan, and largely completed step two (we still have a few student loans, but no consumer debt).

Thus, my real decision was between jumping ahead to Dave’s seventh step or going back and finishing up step two and working on step six. I think that most people would agree that steps one through five make a lot of sense - build an emergency fund, get rid of all of your high-interest debt, build a strong retirement plan, and fund college for your children. After that, it gets a little bit hairy.

For the long term, it usually makes sense to jump into investing at that point, if your only debt is your mortgage (in our case, we lumped student loans in with the mortgage because they’re fixed rate loans below 8%). With a time horizon of better than ten years, making minimum payments on your loans and investing for the long term will net you more money.

However, investing first assumes that you are not considering any significant lifestyle changes and are planning on steady income. The rules change in our case, because we are strongly leaning toward a stay-at-home option for one or the other of us. Thus, even though we have a long time horizon, our shorter-term goals (being a stay-at-home parent for a short period) have more urgency than our longer-term goals - our children are only young once, and when they’re in school, we both plan on working again. We still plan on looking for that country estate, but it’s worth it to us to push it off for a few years so we can provide a strong personal foundation for life for our children.

Because of that, focusing on debt reduction, as per Dave’s plan, makes more sense to us. It reduces our monthly bills by a significant factor (eliminating all of the student loans before one of us stays at home will reduce our bill load quite a bit) and our “investment” in debt repayment does pay 7-8% guaranteed (depending on the interest rate of the student loan).

So what about Dave? Dave Ramsey’s plan is a brilliant starting point, particularly if you’re completely unsure about what to do with your financial situation, but it is not gospel. Different situations require different plans - there is no “one size fits all” financial planning solution. If someone tries to sell you one, run away fast.

The debt turnaround that my wife and I experienced over the last year and a half opened this door for us. Without really discovering frugal living and the value and need to get out of debt, we would never be in a situation where we could realistically consider one of us making a major life change. Regardless of the decision we make here, our foundation is far, far more solid than it was eighteen months ago.

Over the last few weeks, my wife and I have taken some serious looks at our overall financial state, our happiness with our current lifestyle, and whether or not one of us wants to become a stay-at-home parent.

Although we’ve not reached a consensus on all of these issues, we have agreed on one fundamental fact: all of our leanings point toward debt freedom in the short or intermediate term as the best possible solution for our extra money.

Here’s why.

First of all, there’s a decent chance that one of us will become a stay-at-home parent. That means loss of income in the next year or so, meaning that our surplus money now will dry up. Instead of investing it, we can use the next several months of that surplus to eliminate some debts, thus reducing the size of our monthly budget and making it easier for us to breathe.

Second, it reduces the risk of potential career change. If I ever work up the courage to make a go of it and be a full-time writer, the case for it will be strengthened by a reduced debt load at home. If our debts start eating up a smaller and smaller percentage of our monthly budget, then I’m more and more likely to be willing to make that leap.

Finally, it somewhat reduces the risk in almost every aspect of our lives. Our current debt payments (home mortgage included) add up to over $2,000 a month, and actually make up a large majority of our expenditures in a given month (we spend less on utilities and food and cars combined than we do on those debts). $2,000 each month, floating free in our budget, changes a lot of the risks we face in life - the financial risk of having more children, for example, is a big one on our mind right now.

Thus, we’ve decided to focus primarily on repaying debt for the next year and halt our non-retirement investing plans. Our tentative goal is to pare things down to just our home mortgage within a year, and when we reach that point, re-evaluating things to see where we’re at.

What’s the plan?

First, we figured up all of our debts, and then ordered them by interest rate. Our total debt right now is actually $211,218.92, which is a scary number when you sit there and look at it. Thankfully, that number is all below 8% interest, which makes it somewhat better.

Next, we will make all minimum payments out of our normal monthly budget. This means that from the pay from our “regular” jobs, we’re going to make the minimum payments on all of the debts each month.

Then, we’ve committed all extra income (from side businesses and freelancing) entirely towards this goal. All of that money, once taxes are paid, will get swept directly into debt repayment. Note that this is after minimum payments are made, so this is all directly attacking the principal on the debts.

This will continue until all but the home mortgage is eliminated (which also happens to be our lowest interest debt), at which point we’ll step back and re-evaluate the situation.

This post is part of The One Hour Project, in which you can spend just one hour to put your finances in a better place without a big lifestyle change, through frugality or other financial choices.

If you’ve gone through even a few of the one hour projects in this series, you likely have some more money in your pocket. Don’t rush out and spend that jingle - instead, use that jingle to repay your debts, even if it’s just a few dollars a month.

Here’s how the debt snowball idea works. A debt snowball (or similar arrangement) is simply a debt repayment plan that specifies the order in which you should pay off your debts. Typically, there is some logic in the order - in Dave Ramsey’s original debt snowball, the debts were ordered from smallest to largest, for example. You then add up the minimum payments for this snowball, add an additional amount to that total, and then treat that dollar amount as your “debt bill” for the month.

From this “debt bill,” you make the minimum payments on all of your debts, then use the remainder to make extra payment on whichever debt is on top of the list. When that one is paid off, you don’t reduce the total of your “debt bill” - instead, you just have a larger remainder to tackle whatever debt is now on top of the list. Eventually, you’ll be using the whole “debt bill” amount to tackle that final debt - and it will melt away quite quickly.

If you’re spending less than you make but you still have a lot of debt to tackle, a debt snowball is a great thing to start. It commits you to actually getting rid of your debts - and debt freedom is a beautiful place to be.

How do you set this up? It’s pretty easy - all you need is either a piece of paper or a spreadsheet. Here’s the game plan.

First, find the interest rate, minimum payment, and outstanding balance of every outstanding debt you have. You should be able to get this information from the last statement of each of these bills.

Next, sort these bills. I recommend sorting them by interest rate, with the highest one on top. Another method is to sort them by the outstanding balance, with the smallest one on top. What you’re doing here is figuring out the order you’d like to see these debts gone.

Now, list the debts along with their minimum payment in the order you sorted them. You’re going to add up the minimum payments, so keep them in a nice column so you can easily add them up.

When you have them all listed, add up the minimum payments. This should give you a nice fat number - that’s how much of your income each month goes to paying off stuff you had to have before you could afford it. It’s a number that you want to knock down to zero.

At this point, you need to take a look at how much you spend overall each month. How much extra can you squeeze out? If you’ve been doing the one hour projects, you’ll probably be able to squeeze out at least a little. Commit yourself to spending a certain extra amount each month to getting yourself debt free.

Add this number to your minimum payments. This is how much you’re going to commit to your debt each month. I found it psychologically useful to find that number I was comfortable with, then rounding it up to a larger number, a nice even target for each month.

When you figure up your bills, use this total number instead of the individual minimum payments. Your “debt bill” is now this number.

When you sit down to pay the bills, make minimum payments on all but the top bill on your list. Then, for that one remaining bill, write a check for the remainder of the money you put aside for debt that month.

Repeat this exact bill paying procedure without changing the total amount you’re putting aside each month until your debts are gone. Obviously, you may want to refigure things if a major life change occurs, but unless something really big happens, stick to the snowball. It will get you out of debt.

The one personal finance issue that I debate internally over quite a bit is whether one should pay off debt or invest if all they have are relatively low interest rate debts (7.5% or less, for instance). All of my remaining debts are below 7% and, thanks to careful frugal living, my spending is quite a bit below my earnings each month.

My current plan is that I take that excess and split it 50/50. Half of the excess goes towards debt repayment (I’m making extra payments on my highest-interest loan right now) and the other half goes towards investing in building a small portfolio of Vanguard index funds (which I’ll talk about someday, but isn’t particularly relevant right now).

At my innermost core, I believe I should be investing all of the excess. Here’s why:

The return is better. The portfolio I’ve designed has a 13% annual return since 2000. Yes, that includes the dot com bust. That’s far better than the 7% or so return I would get from paying off debts.

It moves us more directly towards our dreams. We have long dreamed of a very nice house in the country, with a large vegetable garden, a small barn, lots of trees, and hopefully no neighbors in sight. Our portfolio is designed to make this dream come true and thus investing now pulls that dream a little bit closer.

We have a big emergency fund. If everything fell apart, we have a cash emergency fund. If we blew through that, we could start pillaging the investments. In other words, having investments keeps us much farther away from the edge of the cliff.

My wife, on the other hand, believes that we should be paying off all of our debts first. Here’s why:

It reduces our monthly expenses much quicker. By getting rid of our debts as fast as possible, we reduce our required monthly expenses much more quickly than with a pure investing plan.

It provides a tangible goal that keeps us motivated. We know the exact dollar amount of our debt and can use that as a constant motivator. It’s much easier to pull money from a more nebulous investing goal.

Freedom from debt means we never have to go back. The idea of being completely free of debt has a lot of psychological appeal to both of us - not owing anyone a dime sounds quite good.

Which is right? One could argue this subject until the cows come home without resolving it. Both aspects have valid positives and valid negatives. My belief is that if you assume personal stability over the next several years, the investing solution is better - however, if a major life change happens soon, you’ll be much happier without the debt.

So what’s the answer? Spend less than you earn, then do what seems right for you. You’re not going wrong by paying off your debts quickly, or keeping debts while investing rationally. In both cases, you’re still sticking to that central idea - just spend less than you earn.

Where do you fall in this debate?

This post is part of The One Hour Project, in which you can spend just one hour to put your finances in a better place without a big lifestyle change, through frugality or other financial choices.

Keeping your focus on getting out of debt can be a challenge for some people. It’s so incredibly easy to just not think about it at all and make a bad financial choice, like putting something unnecessary on the credit card or going out for an expensive dinner and drinks.

One of the most effective tools I use to remind me of my progress is a visual debt reminder. It’s simply some sort of visual item that reminds you of your commitment to reduce or eliminate your personal debt and also to simply spend less than you earn.

The inspiration One form this might take is an image of that which is inspiring you to become debt free. For me, this would be my children, particularly my son who was the person who really inspired me to start turning things around.

The goal If you have a specific goal in mind, you might also want to include a picture of this goal. My wife and I have a 15 year goal of buying a piece of land in the country and building a home on it, so for us we would potentially use a picture of a country home as our visual reminder.

The progress bar You might also want to construct a progress bar that shows your progress as you move from your current debt total to zero. Each time you calculate your debt total, you’ll (ideally) move a bit closer to zero, so you can fill in a bit of the progress bar.

What I did for myself was combine different elements. I digitally placed a progress bar at the bottom of an image so I could see myself progressing towards the goal of being debt free.

What should one do with such a reminder? I keep such reminders all over the place: on the dashboard of my truck, in my wallet wrapped around my credit cards, and in a few other places where I’ll see it regularly. It constantly reminds me of my goals and my real priorities and cuts down greatly on the influence that spur of the moment things have on me.

Take a few minutes, sit down at your computer, and create for yourself a visual reminder of your personal finance goals. When you have one designed, print out a few copies and put them in places where they’ll remind you of what your real goals are (I really recommend wrapping one around credit cards, for instance). Then, as you make progress towards your goal, take pride in this effort and start filling in that progress bar. As you see it constantly filling up over time, you’ll begin to see the connection between your good choices and your dreams.

Over the last day or two, I’ve been going through the piles of email that have built up since the birth of my daughter and found a few stories worth sharing, which I’ll be sharing today and (maybe) tomorrow. Here’s the first one, from Amy:

I am thirty years old, college educated, and a certified teacher. For the past several years I have taught school and used that money to buy a house with an ARM. This past January I sold the house. The 18k I made on the sale I rolled over to pay debts.

Last year I took out credit cards and my intention was to sell the house and pay the cards. However, several small things like car accidents, a move to an apartment, and buying a truck took the air out of the plan.

When all was said and done, I still have $4,000 in student loans, and $35,000 in unsecured debt.

Now here is the sad part of my story. I was advised by a friend to “just walk away” from the unsecured debt. “Pay the student loan and forget the rest.” This came from a banker. “In a few years you will not have the unsecured debt. It will be a write off. Disappear for a while.”

Since I am a teacher, I decided to take a job overseas. I was being paid to teach under the table. It was not the best idea. I decided after two months to face the music, come home and start again.

Which leads me to today. I have no money in the bank. I have $35,000 in unsecured debt. My student loans are paid through January–but then I have the payment coming back at me. I have no assets except my truck, paid for, and my laptop. Luckily, my brother is letting me stay at his house while I look for a job.

Any advice you can give would be appreciated.

Before I say anything else, please note that if you have a significant amount of credit card debt, re-read the story above. It could happen to anyone who puts themselves in a shaky financial position.

First of all, I fully understand the logic behind the advice from the banker, but it’s not good advice for the next several years unless you intend to live elsewhere. Why? Doing that will destroy your credit and leave you with harassment from creditors for many years. If you live in a situation where it’s difficult for them to contact you and your credit doesn’t matter, then this might be a good move, though I personally consider it dishonorable to walk away from your debts.

So what can you do in your current situation? Here are the steps I would take to get back on track.

First, I would focus very hard on getting a job, even if it happens to not be a teaching job. Work evenings somewhere so that you at least have some income coming in, then beat the streets for other work during the day.

Next, I would utilize a reputable credit counseling service. This is a significant enough debt situation that most normal debt repayment plans will probably not work. As a general rule of thumb, for-profit agencies are generally less helpful than non-profits. I would start with Consumer Credit Counseling Service, though that’s not a recommendation.

Also, live as cheaply as you possibly can. Don’t spend a single dime unless you have to. Live like you were in college again, eating ramen noodles and living in a tiny room. Focus on getting your finances healthy before raising your standard of living.

Another tip: don’t be afraid to look for charity right now. Talk to local pastors and see if you can at least get some free meals. Don’t be proud - pride right now will cost you.

Perhaps some readers will have additional advice for Amy.

I received a really interesting story from a reader named John. He has his financial head in the right place, but some other pieces of his overall life puzzle aren’t quite in alignment. Take it away, John:

I am 29 years old and I have just recently started to jump into real estate investing part time in my hometown. I currently work a regular full time job that pays $43K a year. Just last month I sold my first “project house” and used the profits to be completely debt free (other than my $110K mortgage, 5yr fixed @ 5.9%). I also now have $40K left over sitting in a high interest savings account (5.05%). My plan was to hold onto this 40K and use it to further my real estate investing career. I would use it for downpayments, renovations etc. Without this money, I really do not have any other way of purchasing my second “project house”.

I have been living with my girlfriend for over 2 years now and I am 90% of the way to having the money saved to buy her an engagement ring (should be there by Nov). She just finished school and is coming out holding a little over 20K (interest of ~6% on both) of school debt. Her current full time job is paying her only ~$30K a year.

My question is this:
Should I use 20K of the 40K that I have saved to pay off these student debts?

Pros:
* 20K will take her quite some time to pay down when she is only bringing in $1500 a month and it will be pretty hard on her.
* She (we) will save quite a bit in interest costs by paying this off completely.

Cons:
* This move would limit my RE investing options, as I would only have about 20K to work with.
* I am worried that she won’t learn the value of being debt free as she hasn’t experienced what it is really like to be frugal.

John’s in a situation where there are a lot of questions about his immediate future that he needs to answer. Let’s move through some of these questions one at a time and see how they affect John’s best move.

First, is she going to accept his marriage proposal? This is a very important question because it may likely lead straight into wedding expenses and other such costs associated with this, meaning that he probably would want to have the cash for the wedding liquid rather than tied up in real estate.

Next, would he still want to pay off her loans if she didn’t accept the proposal? Some people might automatically believe the answer here is “no,” but it depends on who John is as a person and also the type of relationship he has with this woman. If the debt repayment is contingent upon the proposal or upon the marriage, then he should wait to pay it off - if it is not, he should pay the debt off immediately.

Also, how valuable is this real estate investing career? For time and money invested, how much did John actually make on the first house? I would figure up an hourly rate including all time invested and all costs and see how it did. If it’s minimum wage or less, the real estate career should be viewed as a hobby and put somewhat on the back burner compared to eliminating debt and paying for the wedding.

I’m also not sure about the comment about “hasn’t experienced what it is really like to be frugal.” I think that’s an issue you need to talk about within the relationship, as there is no advice that can really be given to address that aspect that isn’t pushy or assumes quite a bit about the relationship. Just sit down and talk about frugality and spending - make sure you both understand that the best way to go over the long term is to always spend less than you earn and the bigger the gap, the better.

My perspective is this: if you are sure that you are going to be married in a year or two and you’re not in the middle of a real estate boom, your best bet is to pay off her debt immediately, then pay for the wedding without incurring more debt. If either of those assumptions are in question, then the situation requires a lot more detailed thought.

Of course, with a situation as complex as this, I’m sure my readers will have some additional ideas.

I get a lot of email from readers (and from spammers) about so-called debt elimination programs - organizations that promise to “eliminate” large portions of your debt and leave you debt free in a certain number of years. Do they really work, or is it a scam?

I looked into several of these via “free trials” and almost every one of them was essentially the same - a compilation of decent personal finance advice crammed together in the framework of a plan. Most of them included a computer program to create a simple monthly budget for you and also tell you which debt to pay off first and how much to pay on that debt - essentially a computerized version of Dave Ramsey’s “debt snowball.”

Do these programs “eliminate debt”? They sure do, but probably not in the immediate “debt free” sense that you’re thinking. Instead, they put you on a very hard debt repayment course that’s designed to have successes along the way so you can feel like you’re making real progress, plus they usually tell you to call creditors and negotiate with them, offering some basic techniques for doing so, or encourage you to visit a credit counseling service.

These programs also claim to raise my net worth? Whenever you start paying off debt, your net worth will begin to go up over time - or at least the downward slide will begin to slow. Let’s say you have $20,000 in assets, make only $150 a month, and you have $10,000 in debt at 18% interest. Your net worth is $10,000, but you have to make payments of $150 every month just to stay in place - and this situation will continue forever. If you instead make payments of $300 a month, the first month will see no difference in your net worth - your assets will total $19,850 and your debt will total $9,850, giving you a net worth of $10,000 again. But the following month, that $300 will pay more principal and less interest than before - your debt is smaller and thus doesn’t earn as much interest - and so after the second month, your assets would be $19,700 and your debt would be $9,697.75. Your net worth is thus $10,002.25 - it’s gone up just because you’re taking care of your debt. The increases in net worth occur because of the decreases in debt.

This sounds harder than the ad makes it sound. It is - there is no legal method of getting completely free of your debts. These plans are just like any such “life transformation” plan - they work spectacularly well if you’re truly committed to the change, but they aren’t worth the paper they’re printed on if you’re not. Even more importantly, such programs are usually made up of information that’s available for free - or close to it - elsewhere.

Here’s the scoop: if a program like this is appealing to you, instead just go to the library and check out Dave Ramsey’s book The Total Money Makeover. The meat of these debt elimination programs can be found in that book - and the book can be checked out for free at your library instead of paying the exorbitant cost of the debt elimination program.