Getting rid of your debt
...while keeping your sanity.
Not too long ago, I was in over my head in debt. It’s no secret that I am a man of means, but no matter how much money you make, if you spend more than what is coming in, indebtedness is the only result. Of course, it did not help that I am a non-classically educated man–meaning I paid for my own education. I spent 10 years in college, graduate school, and law school. The result was six figures in student loan debt and a minimum monthly student loan payment of nearly $1,000, plus consumer debt that, after a cross-Atlantic courtship and a self-financed wedding also topped six figures.
We have crossed the debt Rubicon.
I tell you all this because, as Americans, we have crossed the debt Rubicon. We have to begin to face our consumerism and our debt issues openly and honestly. This is as true of our personal debt as it is of our public debt. The first step in that process is admitting that you have a problem. I am happy to report that, after about three years of focusing and firm, but not psychotic discipline, my wife and I have weened our consumer debt back down to nearly four figures and expect to pay it off in the next six months. The purpose of this article is to provide generalized guidance on how you can do the same.
First, some emotional advice: take a deep breath and relax. This is a marathon, not a sprint. Nothing is going to change overnight. Just like it took years to get this far into debt, it will take years to get out of it. Don’t dwell on the money or the depression. Don’t think about what you can’t have. Think about how much money you’re paying off each month, and then think about what you can do with that money when you’re free from debt. It will make your heart sing, trust me.
Second, a few disclaimers: this is not for people who are truly insolvent. If you are unable to make the minimum payment on your loans and credit cards, you need to seek protection, possibly in bankruptcy. This post is meant for people who have a lot of debt and are feeling overwhelmed. If you’re beyond that and are already defaulting on debt and receiving calls from collection agencies, you should get help elsewhere. There are places you can go for that guidance, some starting points are listed below. Everyone’s tolerance and preferences are different. Saving money is like dieting. Some people can go cold turkey and make drastic changes and stick with them. Dave Ramsey is the guy for you. Other people need to live by the 80/20 rule: live within the lines 80% of the time and relax and have the chocolate cake 20% of the time. If that sounds like you, this may help. A word about credit counseling: anyone who tells you to stop paying your credit card companies is a scam artist, drop them like a hot rock. A legitimate credit counseling agency would not put you at risk of default, but would negotiate better terms while you repay your credit cards.
This is the Law of Unintended Consequences once again slapping Congress in the face, but consumers are the ones feeling the sting.
Third, some lay of the land: as I have already mentioned here, and here, I am not a fan of the newly passed Credit Cardholders Bill of Rights. I work in the industry, so I suppose I am biased, but even so the unintended consequences should have been obvious. Although the credit card companies have made some egregious errors in judgment and there are clear systemic problems, these laws create massively perverse incentives against consumer interests. Banks will not lose money. They will always find a way to protect their financial interest within the rules of the game. As you may already know, credit card companies are reducing cardholders credit lines, changing grace periods, and increasing their base interest rates. Many industry experts predict that 0% interest teaser rates and some rewards plans may also go away. This is the Law of Unintended Consequences once again slapping Congress in the face, but consumers are the ones feeling the sting.
So how to navigate this new morass, and get rid of your debt while keeping your sanity. The general plan is to payoff the credit cards as fast as possible. The way to do this is to get the lowest interest rate possible, so that your payments go towards principal, rather than interest. The best way to ensure you’re getting the best interest rate is to know and improve your FICO score and your credit history. Here are some simple steps to do that, and more importantly, why:
FICO Score: The first thing you need to do is obtain and monitor your FICO score and at least one credit report. I use MyFICO.com, but FreeCreditReport.com and others are just as good. You should check your FICO score and your credit report at least once per year under normal circumstances. If you’re looking to make a major purchase (like buying a house or a car), just paid down a large amount of debt or made other changes, you should check more frequently. I subscribe to MyFICO’s monitoring service, which notifies me when my score fluctuates by more than a set amount. I recommend that service, which costs about $85 per year. Why? Credit card companies and most financial institutions base most of their decisions on your FICO score. It may be unfair, but so is life. If you know your score, you will know your chances of being approved for a 0% interest credit card, a mortgage loan or any other loan or insurance policy. Knowing is half the battle. The rest involves objective setting and TPS reports.
Knowing is half the battle. The rest involves objective setting and TPS reports.
Use Your Credit Cards More: This may seem counter-intuitive, but you need to use your credit cards–or at least one of them–more often. Credit cards are a financial tool (said the guy who works in the industry). When used properly, they allow you to stretch your purchasing power, keep better control of your expenses, avoid carrying cash and checks, and a whole host of other benefits. If you use them properly, there is no reason you will have to go into debt. BUT, YOU MUST PAYOFF THE NEW AMOUNT EVERY MONTH. If you don’t do this, you will only be making things worse. Pick the card that meets the following criteria: (i) a good rewards program that you can actually use (points for air miles are great, but if you don’t travel a lot, what good does it do you? And should you really be traveling a lot if you’re trying to pay down $60,000 in debt? I’ve picked one with retail gift cards to give me more flexibility.); (ii) enough credit limit remaining to provide you with 1.5 months of recurring expenses (more on this later) and (iii) a reasonably low interest rate (this is only important if you need to carry a balance on this card–if you are starting from zero, the interest rate is irrelevant). Then take this card, your new utility card, and do three things (a) use it for your recurring payments (more on that in a minute); (b) move it to the front of your wallet for groceries, gasoline and all the other expenses your now paying in cash or debit and (c) if possible, move any balance you have off of that card (it’s best to start with a brand new card with no balance, but if your credit isn’t great, this may not be possible). Recurring expenses are monthly payments like your cable bill, your phone bill and your mobile phone. Contact all of these companies and put them on auto-pay with your credit card. Most companies will be happy to have the certainty of a credit card on file. Some utilities, however, (like Con Ed) will charge a “convenience fee” for accepting credit cards. Don’t pay this, it’s a waste of money. Just keep paying them by check until they join the 20th century. (That wasn’t a typo). Why? This will do several things:
- Rehab. Most importantly, this will rehabilitate your credit. When you pay your bill, credit card companies generally put you into one of three categories: (a) paid less than the minimum; (b) paid the minimum; or (c) paid more than the minimum. Most companies will put you in the last category even if you pay a dollar more than the minimum. If you put recurring payments and ordinary expenses on your credit card and pay off the entire amount every month, your credit history, and eventually, your FICO score, will improve.
- Affluency. Charging these amounts (and paying them off every month) will make you a medium to high-spend customer–your bank’s favorite friend. If you’re like me, a family of two, you spend about $450 per month on cable, telephone, internet, mobile phone, NetFlix and other assorted recurring bills. Groceries add another $1,200-$1,300 per month and gas adds another $250. That’s $2,000 per month in expenses or $24,000 per year. Keep in mind, this is money that you are already spending. Banks earn money every time you use the card, even if you pay it off without paying interest. (See my post here for more on interchange). The bank will love you and it will treat you very differently than a customer that keeps a few thousand dollars and pays the minimum every month. You will get more and better offers (and if you’re not a platinum cardholder, you probably will be soon) and when you call to negotiate a new rate, your spending habits will be taken into account.
- Simplicity. This will uncomplicate your life. The utilities and other expenses you have to pay every month are to about 5-10 different companies. This will make all those payments into one company at one time each month. You can schedule this payment to coincide with the paycheck opposite your rent or mortgage payment. (Banks will work with you to reschedule your due date.)
- Interest Free Loans. Credit cards give you a 20-28 day grace period (but the calculation of interest on the grace period often depends on whether you carry a balance, which is why its best to start with a blank slate). By using the grace period, you’re stretching your money and taking a 20-28 day interest free. Although your cable bill gets paid on the 1st, you might not pay off your credit card until the 20th. For 19 days, that money sits in your checking, money market or savings account earning interest. It may not seem like a lot, but $24,000 earning interest over the course of a year adds up. And its money your giving away today.
- Rewards. Rewards points will accumulate fast. If you’ve selected a card with a rewards program that works for you, you will see the effects almost immediately. We use a Citi card with the Thank You Points program and redeem the points for retail gift cards. 6,000 points equate to a $50 card, so about every 2-3 months we can get a $50 gift card for Best Buy or Bed Bath and Beyond or somewhere else and either buy something we need or something we want, but wouldn’t otherwise be able to afford.
- Protection. When you buy things with your credit card, depending on the brand and type of card, you will probably be getting price, warranty and theft protection under your card agreement. This may not help for your weekly arugula salad, but it will help when you buy something at the drug store or supermarket that’s meant to last past dinner time.
Zero Percent Interest. This is the key to a speedy payoff: getting and manipulating zero or low-interest cards. First, you should not apply for new zero percent credit cards if your FICO score is well below 700. The market is still adjusting, but if your credit score is at 650 (the old “good credit”) you may want to try. If you’ve rehabilitated your credit and you’re ready to start looking, try www.creditcards.com. They provide a list of credit cards by type (zero interest, balance transfer cards, rewards, etc.) The risk in applying and getting turned down, of course, is that by merely applying for a new credit card, your FICO score may go down. (Your FICO score, among other things, is based in part on the number of times banks have looked into your credit history in the past six months. So requesting a new credit card, asking for a higher credit line or applying for a loan are all things that should be done sparingly.) The second option is to use what you already have. If banks are not already, as you repair your credit, your existing banks will begin sending you balance transfer offers. These rates are calculated based on your FICO score and credit history. The better your history, the better your rate. Here are some suggestions on how to use the zero percent or low interest rate cards:
- One Basket. Do your best to pick one card per year (most offers are good for 12 months) and load up only this card with all of the debt you are carrying. This may not be possible at first, but work towards it as your goal. This will do two things: (a) it puts all your eggs in one basket; you only need to make one payment per month and you will know how much you owe at any moment; (b) when it comes time to transfer the balance, when you get another card with a limited balance transfer fee (these are becoming more rare), you will only pay it once. For example, let’s say you owe a total of $30,000. If Capital One is offering 0% for 12 months with a 3% fee up to $75 per transfer; you would pay $75 to transfer one balance from, say a Chase card. If, however, that $30,000 was split over 4 cards, you would need to do 4 separate transfers and the fee would cost you $300. That $225 difference is a monthly payment.
- Flip it. As the offers expire, go to the next card or cards in your inventory and transfer the remaining balance to those new cards. This will not be free. As mentioned above, most cards have a balance transfer fee of about 3%, but some still cap this fee at a fixed amount ($75-$150). The offers come out on a monthly basis, usually at the beginning of the month. When you flip, be sure that you don’t miss a payment on the outgoing card.
- Don’t cancel the cards. This may seem counter-intuitive. Part of your FICO score is based on the length of your credit history and the utilization of your available credit. If you drop an existing credit card, your total available credit will go down and you will eventually only have a very short period of credit history with a handful of banks. Moreover, as you accumulate cards, you will get offers on cards that have no balance. Of course, use your judgment. When your debt stabilizes, if you have 10 credit cards and only need three and six of them have a credit limit of $1,000, feel free to cancel those six.
- Keep the Utility Card Separate. Whether you have zero or low interest cards, do your best to keep them separate from the card you are using above for recurring and ordinary expenses. If you are paying that off every month (and you had better be), the interest rate on that card is irrelevant, so don’t waste a zero percent balance transfer offer on that card. (If that bank makes an offer and you need room, do take advantage, but things get complicated as the rules for which balances get paid down vary based on the bank and the new legislation).
The lottery is a tax on people who can’t do statistics
Learn to Live Within Your Means. The first three suggestions were about what to do on a technical level. The rest are about how to change your lifestyle. This is one of the hardest things to do because it requires a fundamental change in your psyche. Nonetheless, this is the most important step because without it, even if you hit the lottery tomorrow (and don’t play lotto, the lottery is a tax on people who can’t do statistics), you would eventually be back in debt. Learning to live within your means requires (i) an emotional detachment to money and consumerism; (ii) discipline to stick to decisions once they are made; and (iii) knowledge and know-how about finance and money. This blog post, even at 3,700 words, won’t get you there. What will is a lifetime of deciding to get back up when you’re knocked down. Here are a few suggestions to start you on the path:
- Pay Yourself First. One of the easiest and most effective ways to learn to live within your means is to pay yourself first. Decide on an amount of money that you can live with each month, call it an allowance, a stipend, a tin or petty cash. Put that money aside in a separate account or withdraw it into cash in your wallet or a coffee jar. Do not mingle it with household money or use it for groceries or gas or any “needs” or to pay off debt. This is a promise you’re making to yourself. Use this money for movies, dinner, drinks, a pedicure–all of the fun stuff that make you happy and make life worth living. Why? Saving and dieting are like holding your breath under water. If you go too far too long, you’re going to come up gasping. You need to have an outlet to allow yourself life’s little pleasures on a regular basis so that you don’t snap and binge. I take about $600 every month for personal expenses. For me, this includes snacks, (I don’t drink coffee), dinners away from home, gifts for my wife, toys for my dog, the occasional Wii game, etc. If you’re struggling with debt, $600 is obviously a lot of money, and you need to set an amount that works for you. But do it knowingly. You need to add up all the Starbucks runs, all of the lunches, all of the McDonalds, all of the candy, cigarettes, skoal, and every other little personal item. And then you need to decide, am I going to give it up or am I going to make it part of my stipend. Either way, you are spending the money now.
- Situational Awareness. “Budget” is one of the scariest words for people with financial problems. If you’re like me, it conjures up thoughts of spreadsheets, gut wrenching conversations, belt tightening and buckets of antacid. As I note below, there are alternatives to rigorous budgets, and if you’re like me (I hate calorie counting, too), All Your Worth, is a good place to start. But what you do absolutely need to do is figure out where you are now. Invest in a program like Quicken or Money or use a free online program like Mint.com to keep track of your finances. This will help you find recurring expenses, know how much you’re spending on groceries and find places to save money. In addition, just like the journalist’s diet, just knowing how much you’re spending will help you curb unnecessary expenses.
- Debtor, Heal Yourself. Often, one of the hidden reasons for debt is another, related issue. Now I hate psychobabble, so let me be clear: I am not saying you use credit cards too much because you weren’t breast fed (or you were breastfed too much). But if you are, like I am, overweight, or if you have emotional issues like one of my friends did that meant her self-worth was tied to shopping, these are serious problems that need to be fixed. Most healthcare plans will cover weight-loss and psychotherapy. If you’re covered, look into your plan’s coverage and see what the options are. If not, look at your employer’s mental health benefits. They may have counseling that you can go to. Why? Taking obesity as an example: I recently went on a diet and lost 30 lbs. I feel great and am in far less danger of dying before 40. But financially, I am also better off. My body needs less food at every meal, instead of eggs, bacon and a snack for breakfast, I have a shake. My snacks between meals are limited to protein bars ($2), rather than candy bars, soda, chips, etc. ($5-7). Over a week the $3-5 adds up to $20-$30. For lunch and dinner, I no longer go for the chicken parm hero or the extra food with my meal. Some slices of chicken breast, some broccoli and carrots and I’m full). I save on food, clothing and even utilities (skinny people don’t need the thermostat set at 65º–although that may have a reverse effect in February).
- Read. There are a few books that changed my perspective on money and made me stop chasing the Joneses. Rich Dad, Poor Dad, by Robert Kiyosaki, Atlas Shrugged, by Ayn Rand, and All Your Worth: The Ultimate Lifetime Money Plan by Elizabeth Warren, Amelia Warren Tyagi. Rich Dad, Poor Dad made me question my understanding of consumerism and whether I needed a big house, a BMW and a large screen TV. (No, no and yes). It will also make you realize that being an employee is not such a great bargain. Atlas Shrugged will make you appreciate capitalism and money in a way you probably have not before. All Your Worth provides an easy to use budget theory that you can apply to your lifestyle without being a CPA.
- Get support. Talk to people who are going through the same thing. If your married, be open and honest with your spouse. There’s nothing worse than bearing the burden of crushing debt alone, especially while your spouse unknowingly spends you both further into debt. It’s not fair to either of you, and it will strain your marriage and only drive you deeper under. If you’re not married, find friends who are going through the same thing and rely on them. If you don’t, you’ll be hanging out with people for whom money is no object. That’s what got you into this in the first place.
Reliable Resources for Credit Counseling and Financial Literacy
Start with these webstites and come back to them to check on any credit counseling agency you may be thinking about. Keep in mind, there is no such thing as a free lunch.
- Feed the Pig Financial literacy and savings non-profit.
- MyMoney.gov Government-run website that provides information on credit counseling companies.
- National Foundation for Credit Counseling These are accredited credit counselors who will work with you to develop a debt management plan (similar to bankruptcy, but voluntary). This will adversely effect your credit rating, so don’t do this on a whim.
- MasterCard’s Debt Know How. Financial literacy program. Priceless (and free).