Money matters are certainly on a lot of people’s minds these days. Concerns about a recession and possibly a depression, government bailouts of financial institutions and automakers, the holiday retail season , and a dozen other things. Our household has been no different.
It tough for me to admit that we’ve made lots of financial blunders, even the same ones over and over again. Of course, I thought I had it all figured out in college until the credit card offers started coming in. I fell into the trap of thinking that I needed a credit card to ‘build credit’ to buy a car or a house later. That’s where it all went wrong.
The Debt Myth
Dave Ramsey points out that credit is one of the most aggressively marketed financial products ever. It is so pervasive in our society that most people could not fathom living without debt of some kind. The reason is that it plays to our instinct that we’ve got to have more stuff. We’ll figure out how to pay for it later, just give me more stuff. Think about all of the “0% interest” and “No payments for until 2040″ ads you hear or see on a daily basis.
I’ve talked to people who have elaborate systems for transferring their debt from one credit card to another every few months so they can keep paying low interest. No doubt it works, but it’s clearly walking a tightrope and eventually you will make a mistake and fall. A lot of people are finding themselves in similar situations because they bought way more house than they could afford at low interest rates thinking they would sell or refinance before the interest rates went up. Only the value of their house went down faster than their equity went up and they’re upside-down and default.
Is Debt Free?
I’ve been ‘debt-free’ several times in my life. I’ll work like a dog to pay everything off, but because my spending habits and basic philosophy about money hasn’t changed, I end up doing it all over again. It’s like a smoker claiming that they quit every time they extinguish a cigarette.
This time, though, I’m vowing that it will all be different. After reading, The Total Money Makeover, my wife and I sat down and discussed the principals and our goals of where we want to be. The first goal is to be debt-free except for the mortgage and the student loans within 12 months. This is quite aggressive when you consider that this includes some medical bills, a loan for a piano, and two cars.
Fortunately, we already recognized that we were getting killed by credit card payments and took steps to consolidate those earlier this year with a 401k loan that is paid directly from my check. This may not have been an ideal move and one I may not have done if I had been listening to Dave Ramsey before I did it. However, the 401k loan has a definite end date, a significantly lower interest rate (which I’m paying to myself), and the payment is less than 1/4 of what the combined minimum payments were. I’m not counting this loan in my ‘debt-free’ goal as it’ll take care of itself.
Before we could start the baby steps, we had to do two things: commit to never using credit ever again and develop a budget.
I’ve done budgets before. Simple, right? Take a guess at how much you need to spend in each category and make sure you don’t spend in total more than you make. Doesn’t work, I always overspend. The trick that no one ever tells you is that I need a 0-sum budget. Every single penny of income must be earmarked for something.
What we discovered works for us is that we first make sure there is a minimum amount in the savings account for the emergency fund and a minimum amount in the checking account so we don’t have to worry about overdrawing if we get stupid for some reason (shouldn’t happen, right?). If either account is below the minimum, we get them to the minimum before spending anything.
Then we start subtracting committed expenses for the month (electricity, mortgage payment, water, cable TV, cell phone bill, etc). Then we budget for items that we will need to spend (gas, groceries, entertainment, etc). Then we take out minimum payments for debt (piano, student loans, medical bills) so they all get paid. Then, and here’s the important part: anything that’s left gets added to the Debt Snowball.
Cash is more painful to use than writing a check or swiping the check card. So, anything that we’ll be spending throughout the month is taken out in cash and placed in envelopes marked with what they are for. If we run out of cash in the grocery envelope, we either have to take it from another envelope (e.g. entertainment) or not buy groceries until the next month. The result is that no one needs to carry a checkbook or check card around with them for any reason. Anything in the budget that can be paid through online billpay is directly taken out of the account and everything else is taken out in cash.
The main reason budgets didn’t work for us before is that we tended to leave a ‘cushion’ in the account to make sure we had enough to get by until the next paycheck. The only problem was that as the next paycheck got closer, this cushion became ‘free money’ and tended to get blown on things we didn’t need. There’s no way to do that when you are budgeting every penny.
The Debt Snowball
We’ve taken all of our debts and listed them smallest balance to largest balance regardless of interest rate or other considerations. When we complete our written budget for the month, we take anything that is left and send it to the smallest debt. Once that debt is paid off, the minimum payment that was going to it becomes extra and gets added to the debt snowball.
If I’ve done my calculations correctly, we can easily make our initial goal of paying everything off except the mortgage and the student loans within 12 months. We will continue the same process and I’m hoping it will only take us another couple of years to get the student loans paid off. Once we do that, it’s off to baby step #3.
As I mentioned, we are in a slightly better position than a lot of people starting this process because we already had an emergency fund started and we had recently reduced credit card payments to the point where we could actually start a debt snowball just by creating a budget. However, we were fully prepared to get extremely intense and we had worked ourselves up to quite a state before we actually sat down and realized that we just needed a proper budget.
We were prepared to cancel all forms of entertainment except for the Internet, sell one of the cars, turn off the cell phones, and seek additional employment to make this work. That’s how committed, intense, and fired up we got after reading what’s possible by following this plan and becoming debt-free.
We’re still having to make sacrifices and plenty of them, but fortunately we don’t have to go to quite the degree we thought we would. That makes the victory that much sweeter.