I started writing this as a commentary on Dave Ramsey’s Baby Steps, but found that 2 critial elements were missing. Maybe I’m just dense, but it seems to me steps 1 and 2 (which I’ve added) are critical to the plan, and need to be performed before step 3.
Step 1: Develop a budget, and determine your cashflow.
Before you can begin setting aside an emergency fund, you need to take a step back and determine how you got into debt in the first place. Did you simply decide to purchase too many toys and dine out every other night, entertaining others to perpetuate the illusion that you’re wealthy? Did an extended job loss (without having 3 to 6 months of expenses saved!) force you to max out your credit cards just to make it by for that time? Both of these are more easily corrected as far as balancing the family budget.
But what if you’ve taken a significant, permanent pay cut on your job, or you’ve been laid off and took a lower paying job? What if you, like millions of Americans, were duped by shady mortgage brokers into purchasing a variable rate mortgage and you just received a notice that your mortgage is going up by $500 or more per month? If your budget was tight before these life-altering events, it will surely be even tighter after. In these instances, you may find yourself having to do more drastic cuts to the family budget, or finding a second job.
I would rarely recommend to stop contributing towards a 401 (k) or other retirement vehicle, especially if you have a company match. But if you’re contributing 8% and that money could balance your budget and allow you to pay off your credit cards and other debts quicker, you need to ask yourself some additional questions:
1) How will my getting a second job affect my primary job? Will it interfere and hurt me? Does my company even allow it (some don’t)?
2) How will a second job affect my home life? Will your kids even know you?
3) What is the interest rate on your debts vs. average retirement plan return on investment? If you have $10,000 in credit card debt at 29.99% and your company has frozen 401 (k) matches, you’d be a fool to continue funding 8% into your retirement unless you found a fund returning 30.00% or greater. Take that money and start on the next steps. Get out of debt to those high interest rate cards, and then re-evaluate it when it comes time to start paying off your vehicle(s).
Once you’ve balanced your budget to allow for some extra funds to first put towards an emergency fund, then towards paying off all your debts, proceed to step 2.
Step 2: Ensure you’re insured
Make sure that your financial plan isn’t derailed by a loss of your spouse, or by disability. This could be an extra expense if you’re not properly insured already through your job or privately purchased individual insurance. If you need to purchase more, term insurance prices have dropped considerably in the last few years, and disability insurance is reasonably priced as well. Ultimately, you’ll want to cover all your debts, your children’s educations, and living expenses for a number of years, so if you’re still a few years away from shelling out the educational dough, you could hold off on that part if it’s cost prohibitive.
See my previous post on Life Insurance Planning.
Step 3: $1,000 to start an Emergency Fund
$1,000 may not sound like much, but you will need it to prepare for the inevitable Murphy’s Law events. Your car isn’t invincible, nor is your plumbing.
Or, $1,000 may sound like a lot if you find you never have any money left at the end of the month, which is why you need to put together a budget first.
You should save this in a regular savings account, either with your local bank, or one I would recommend is HSBC Direct. They have higher yields than most banks.
Step 4: Pay off all debt
Lay out in your budget all your debts, their amounts and their minimum payments. Total up that amount, and add to it any and all additional funds you can put towards paying them off. What you’ll end up with is the total amount you will be paying towards debt as a whole until all debt is paid off, a concept known as a Debt Snowball effect. Say for example you have 10 credit cards with interest rates ranging from 9.99% to 29.99%, and balances ranging from $1,000 to $10,000, for a total of $40,000 in credit card debt. The total monthly payments are $800/month. You also have 2 car payments for $400 each, with interest rates of 1.9% and 6.9%. Your total minimum payments then are $1,600/month. You found an additional $400 per month in your budget by eliminating some non-essentials, for a total debt payment budget of $2,000 per month.
This $2,000 number is your budget for as long as it takes to pay off all your debt. Starting with the highest interest rate card first, you apply the entire $400 extra to that card and continue making minimum payments on everything else. When that card’s paid off, you take the $400 extra PLUS whatever the minimum payment was on that first card and apply that amount to card number 2. Even though you’ve paid off a card and no longer have a “minimum payment” liability, you continue paying $2,000 per month toward your debt elimination budget until you get to your last debt (the car with a 1.9% interest rate) and you’re paying $2,000 a month toward that. You really gain momentum quickly once you’ve paid off 3 or 4 cards, and there’s nothing like having the shackles of debt removed.
A WARNING:
There are some companies out there who “specialize” in debt reduction, either by establishing a budget for you similar to the above (and charging you a fee), refinancing your debt into one large loan for a lower interest rate, or negotiating with your credit card companies to reduce your debts. The value of the first one is neligable, and debatable for the second one
The value of the third option is seriously overpromised and underdelivered upon. These debt elimination companies will promise you about a 40% reduction in the debt repayment as a settlement for a fee of around 15% of the original amount. What they don’t tell you is that the 50% reduction will be after the credit card companies’ late fees, over the limit fees, etc., and that you will always receive a 1099 from the credit card company as taxable income for the debt they’ve forgiven.
For example, if you had a $10,000 credit card, you will pay $1,500 for the enrollment into the program. Assume late payment fees and over the limit fees (if applicable) total $1,000, which will mean that the credit card company will settle for 60% of $11,000, or $6,600. At the end of the year, you’ll receive a 1099 from the card company for $4,400, which would add $1,100 to your tax bill in the 25% bracket. Add it up: $6,600+$1,500+$1,100=$9,200. $800 in savings vs. $4,000 promised. And it will hurt your credit score! Don’t do it!
Step 5: 3 to 6 months of expenses in savings
Use a high interest rate, liquid bank account. HSBC Direct is a good one. And remember, it’s 3-6 months of expenses, not of your income, and you will have reduced your expenses by $1,600 by completing step 3.
Step 6: Invest 15-20% of household income into Roth IRAs and pre-tax retirement
ALWAYS put the maximum into your 401 (k) that your company will match (if they’re matching) first. If you’re fortunate enough to have a company match today, it will usually be capped at about 3% of your salary, but funded any number of ways. Some companies match the first 3 percent you contribute dollar for dollar, but a more common approach is a 50% match on the first 6% you contribute. This is free money, and would translate into a 100% or 50% ROI for these two scenarios, respectively. I would put the remainder into IRAs for flexibility, but that’s a personal preference. You could put your maximum amount into your 401 (k), and after that put the remainder in a Roth IRA. You can request a quote here.
Step 7: College funding for children
529 plans are gaining in popularity, and could be a good option, although an IRA would again accomplish the same end goal and would allow for greater flexibility if your genius children don’t need the cash for college with all their scholarships. Work with an advisor who will put you in a good growth fund (indexed annuities are great for this and any IRA as the right ones will give you upside potential indexed to a stock fund, will guarantee a certain percent gain, and will lock in excess gains above the guarantee on an annual basis). You should be able to peg a budget based on anticipated cost when your child is 18, and develop a monthly budget for the college fund.
Step 8: Pay off home early
Put your extra money to work on paying down your mortgage, either extra every time you send in a payment, or lump sum extras once a year (annual bonuses, tax returns, etc.). Making one extra payment per year reduces a 30 year mortgage to 22.5 years.
Step 9: Build wealth and give!
After your home is paid off (and only then), you can start to look into other investments with your extra cash. There is always a plethora of investment options out there, some extremely conservative, and some extremely aggressive. Make sure that your portfolio always matches your risk tolerance, and that you diversify. A 55 year old shouldn’t be in the same investment portfolio mix as a 35 year old.
With your financial freedom, you also have a greater ability to give back to the kingdom of God. Support your local church first, and missionaries through your local church secondarily. If your church doesn’t support any missions works, there are many networks and worthwhile charities to support.
Your blessing of financial freedom will allow you to cheerfully bless others in the truest New Testament context as found in 2 Corinthians 9:6-7: But this I say, He which soweth sparingly shall reap also sparingly; and he which soweth bountifully shall reap also bountifully. Every man according as he purposeth in his heart, so let him give; not grudgingly, or of necessity: for God loveth a cheerful giver.
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