Late last week, I received a very long and personal email from a reader named Susan. Her situation was dire: between the various payday loans and credit card bills, plus the recent disappearance of a live-in boyfriend, she actually owed more in debt payments each month than she is bringing home. Amazingly, she claimed to have only missed one payment for anything in the last year, as her parents have been giving her some money recently for basic living expenses. My initial response was to tell her to file for bankruptcy and let the courts help her get straightened out, but she asked me for a plan for escaping this situation without the use of bankruptcy.
What follows was the ten step plan I outlined for her to help her move from her extremely tenuous position to one with some degree of stability. This basic plan can help anyone who is stuck in a similar situation.
First, seek a loan consolidation. For most people, their best bet is to contact a local credit union and find out their options for a debt consolidation loan. Most credit unions offer an unsecured loan to almost anyone with an interest rate equivalent to a low-interest credit card (9.5% to 17% or so), and they are very flexible for offering these loans to people who clearly explain their situation and have a demonstrable method of income.
If you can secure such a consolidation, then take the loan amount and pay off all of your highest interest loans. These are usually the payday loans and such that charge more than 100% annual interest. Essentially, what you are doing is reducing the payments. For example, let’s say you have $5,000 in payday loans that charge a 10% interest rate each month. This means that every single month, you have to pay $500 just to keep up with the interest. However, if you can get a $5,000 loan from the credit union with an 18% annual rate, you’ll only have to pay approximately $75 a month to keep up with the interest, leaving you $425 each month to pay down the loan. In that situation, you can actually pay off the $5,000 you owe in a year!
If you can’t secure such a loan, you may need to turn to family and friends for help. Ask to borrow money from them, but don’t be hurt if they say no, as a financial relationship may not feel appropriate to them. Use what you can borrow to pay off the payday loans first, as those are the most crippling.
Second, begin paying off your debts, starting with the one with the highest interest. Let’s say you got that $5,000 loan from the credit union at 18% interest, and you currently have $4,000 in payday loans at 10% a month and $5,000 in credit card debt that’s at 31.99%. You should immediately take that $5,000, pay off all of the payday loans, and knock $1,000 off of your credit card debt.
Before this, each month your interest payments alone would total $533 a month ($133 from the credit cards and $400 from the payday loans). Now, your interest payments alone each month total $182 a month ($107 from the credit cards and $75 from the credit union). This leaves you with $351 each month to apply to the principal of the debt. Applying that extra amount to the credit card debt each month will eliminate that debt in one year.
This doesn’t mean to ignore the others; you need to pay the minimum payments each month on all of your debts, but pay as much as you can each month towards the one with the highest interest. If you’ve consolidated some of the debt, you’ll find that you suddenly do have extra money – don’t spend it on foolishness! Pay off those debts now so you don’t find yourself in a sticky situation later.
Third, get rid of your credit cards. Have a moratorium on the use of any credit – I recommend doing this until you’re debt free or very close to it. If you can’t pay for it with cash or a debit card, don’t buy it. You might want to actually cut them up, but you should at the very least do something with them that puts them in a place that’s difficult to reach; for example, my aunt froze her cards in a block of ice.
Fourth, once you’ve reduced your debt payments a bit, learn how to live frugally. Start preparing simple food at home instead of eating take out. Make your own coffee instead of buying Starbucks. Look for free entertainment in your area. Switch to more cost effective light bulbs, like CFLs (this saved me hundreds a year). Learn to love leftovers. Air up the tires on your car. All of these things individually don’t save a whole lot of money, but when they become a pattern in your life, the savings really add up. And the more you do them, the more things you discover that you can do that can save money by living simply.
Fifth, once you can cover all of your minimum payments, pay back what you owe to family and friends. Pay it back with a little bit of interest, even if they didn’t ask for any. Why? The relationships you have with family and friends are worth more than anything else we have in this world. Don’t lose those relationships over some guilt about money and a potential lack of trust between you and someone you really care about. It’s not worth it, no matter what. Pay back personal loans as soon as you possibly can.
Sixth, once you’ve paid off every debt with an interest rate above 10%, start an emergency fund. I recommend putting a tenth of your take-home pay into an emergency fund once your worst debts are gone. What’s an emergency fund? It’s a savings account for the purpose of protecting yourself against inevitable disasters, such as your car breaking down or so on. If you have a healthy emergency fund, you can simply go write a check to pay for such disasters and not sweat it a bit. I recommend getting two months’ worth of salary in the emergency fund for each dependent on your tax return, so if you are a married couple with two children, your emergency fund should be eight months’ worth of salary for all income earners in the house. I haven’t reached that goal myself yet, so I’m still saving about 10% of each check towards the emergency fund.
Seventh, maximize your 401(k) contributions at work. If you’ve killed off your high-interest debt, now is also the right time to start saving for retirement, because the earlier you do it, the less you have to save. Crank up your 401(k) contributions so that you can get every dime of company matching. This level of saving is often enough for people who are on a healthy financial path, and if you’ve paid off all of your high interest debt and are building an emergency fund, you’re better off than most Americans.
Eighth, start a Roth IRA. A Roth IRA is a simple way to get free money. For about $75 a week, it allows you to make money that taxes can’t touch – all of the income from a Roth IRA is tax free. The only drawback is that income from a Roth IRA can’t be touched until you’re 59 1/2, but at that point it’s all yours without tax penalty, to do with what you please. Even if you can only contribute $20 a week, or even less, given the fact that a Roth IRA is perhaps the only free lunch available to you, don’t miss out on it.
Ninth, once you’ve paid off all of your debts, start paying off future debts. This isn’t a time to say “Hooray!” and start spending, not if you want to live a life without the weight of debt on your shoulders. Start a “car” account and a “home” account and start putting money each month into these, hopefully at least a good portion of the amount you were tossing towards debt before. The “car” account will enable you to pay cash for your next car purchase, so that you minimize the amount you have to pay towards a car. The “home” account is saving for some form of long-term housing; if you already own your home at this point, then you can look at it as a fund for a better home, or for home upgrades. You should start an account like this for any large purchase that you anticipate.
Tenth, once you’ve reached this point, start investing. Investing is a completely different ball of worms, but it’s really the remainder of that path towards your dreams. Investments that return well are the way to break free from any sort of financial hold that anyone has on you, which is really the goal that most people dream of.