No Debt Plan

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This is the Eighth post in a series: The No Debt Plan.

If you’ve made it this far, you are too be congratulated. You’ve setup a budget, achieved free cash flow, built up some sort of emergency fund, and as of Step Four are now free of your consumer debt. That’s a huge accomplishment and you should be proud!

The simple fact of hitting those first four targets — a budget, more money coming in than going out, an emergency fund, and debt freedom — puts you in the top percentile of the entire world in terms of finance. Regardless of how much money you earn it is a big step forward from where you started.

At this point in the game, you should know where money is coming in to your budget, and where it is flowing out. You should have an idea of how much you spend on average for various items each month: groceries, gasoline, insurance, etc. This knowledge can help you better plan for your future.

So the No Debt Plan ends here, right?

Not quite! You’ve made it through half of the journey. You started out in the hole. In debt up to your ears. You had no plan, and no idea how much money you spent each month. You’ve made big strides yet there are more to come.

Essentially, you’re halfway through the marathon. You don’t want to quit here, do you?

For the visualizers out there, this is you:

See? You’re standing on top of the mountain. You’ve climbed your Financial Everest. Your friends and family have cheered you to this point.

But just like climbing any mountain, you’re only half done. You’ve got to continue down the other side to complete your summit. Stopping any time before you truly finish is, well, disaster.

Why Continue the No Debt Plan?

You could consistently apply the first seven lessons of this series for the rest of your life and end up okay. I know we can do better. We haven’t tackled real estate, investing for retirement, or even tweaking your current goals.

Stopping now would also not leave you fully prepared for the future. Setbacks will come. You will use that emergency fund some day. I don’t want you to sit in a holding pattern with your finances. Continue to strive forward.

You’re ahead. I’m going to show you how to stay ahead.

Analyze and Adjust Your Goals

Back in Pre-Step Three, I had you define some financial goals. Look back at those goals. You should have them posted somewhere as a reminder of your progress.

If you started my No Debt Plan while in debt, your goals most likely revolved around getting out of debt and improving your life. “Kill off my credit card debt by the end of June 2008″ and “pay off that three year old hospital bill by April 15, 2008″ would have been great goals.

But you’ve begun to change your life. If you are debt free, those goals are gone. Accomplished. Finished.

You need new goals. As with the first exercise, I can’t tell you what they should be. What do you envision your life being like one, three, or five years from now? What financial tasks do you want to accomplish in that time period? Those go here. Some quick examples:

• Pre-pay all insurance on a six month basis.
• Invest 5% of current salary into company 401k.
• Save up $35,000 for down payment on a home.

These new goals are for the downhill slope of your life. The debt is in the past so the debt goals are in the past. You’re headed towards creating wealth and these goals should reflect that.

Your Budget Should Change with Your Goals

A quick sample budget before and after becoming debt free:

• Before
  • Income: $3,000
  • Living Expenses: $2,000
  • Saving: $100
  • Debt Payments: $900
• After
  • Income: $3,000
  • Living Expenses: $2,000
  • Free Cash / Saving : $1,000

In the above situation, you suddenly have a boat load of cash to do something with. Spend it frivilously? No, no, no. Of course not. You need to adjust your budget to match your goals.

Let’s take the example a step further. You’ve got $1,000 to do something with at the end of every month. Your previous goals had that money going towards debt. You are now debt free, so that money needs to go to something new.

If you look at your New Goal List, saving up $35,000 for a home down payment might top your priorities. Well, now you know where that $1,000 is going for the next 35 months. Or maybe you split up the money into several goals. That’s fine as well — just remember the whole point is to tell your money where to go. You’re making sure it goes into a place you want it to go, toward a goal you find important.

New Territory for the No Debt Plan

In upcoming posts for the No Debt Plan, we’re going to step away from knocking out debt. We’re in new territory: wealth creation and smart money decisions. If you ever have any debt questions, please don’t hesitate to ask via the contact page.

But I do want to help you slide down the other side of the mountain rather than leaving you stranded at the top. “I’ve paid off all my debt, woo hoo! … Wait… now what?”

The now what comes next time. Stay tuned.

This has been a long time coming. I’ve been meaning to write this for weeks. You can read more about The No Debt Plan, or get caught up on the first few individual steps.

If you’ve been following the steps of the plan, this is where you should stand:

• You should have a budget, and know where every dime has gone in the past few months. Your budget should tell you where each dime is going to go this month as well.
• You’ve done whatever it takes — cutting of expenses or increasing your income — to achieve free cash flow.
• You have some sort of emergency fund. It could be $1,000 as recommended by Dave Ramsey, or 3-6 months of expenses. Each situation will be different. Do what seems prudent for your family situation. If you have debt, I wouldn’t put more than 6 months away as that may take you a long time.

If you haven’t yet achieved those things you can go back to the steps linked above to catch up. Now, Step Four…

Pay Off All Consumer Debt

Consumer debt is the bane of my existence. Not for me, but for you, my readers. Consumer debt is defined by InvestorWords.com as:

“Debt that has been incurred primarily for the purchase of consumer goods …”

So anything that isn’t your house counts as a consumer good. Some might even consider a house as a consumer good depending on why you bought it.

If you purchased something because you couldn’t wait to save up for it, and you paid interest for it (or still are!) that’s consumer debt.

Some quick examples:

• That 46″ LCD High definition TV that you bought on your Best Buy credit card. Interest rate of 19.99%.
• The new BMW sitting in your driveway, payments of only $499 per month.
• A new iPhone that you put on your credit card for two months with interest at 14.99%.

All of the above are poor financial choices. You’re paying interest on goods that over time will be worth less than they are today.

How to Tackle and Pay Off Your Debt

There are several popular methods to pay off your debt. Dave Ramsey says to go after the smallest amount first regardless of interest rate. Suze Orzman does the opposite. She wants you to pay the minimum payment plus $10 to every debt, then any remaining to the debt with the highest interest rate. You can see a great comparison of the two methods at The Simple Dollar.

So what should you do? What do I recommend?

Do something. Either of the above are fine. I’d rather you start paying extra on your debt whichever way possible. However, tweaking Suze’s method is by far the best mathematically.

3 Steps to Pay Off Debt:

1. Rank your debts in order from highest interest rate to lowest interest rate.
2. Pay the minimums on all debt.
3. Any additional money goes towards the debt with the highest interest rate.

Mathematically, this is the least expensive option because you are actively paying down the debt that is costing you the most every month. It is also the fastest method bearscause you acrue the smallest amount of interest versus the other methods.

Psychologically, it may feel better to pay off several small debts very quickly. I’m not here to make you feel good. I’m here to get you out of debt. I’m not sure why Orzman wants you to pay an extra $10 toward every debt. That’s not going to make a huge difference in interest saved.

Pay off the highest interest rate debt first, and move your way down. And good luck. This step may take some of you years to run through. That’s the consequence of past actions. But stick to it… the grass really is greener on the other side.

I’m looking for a small group of readers — say, 5 or 10, that need guidance on a personal finance level. Sort of like a case study. An example:

Reader Johnny Smith is $18,000 in debt, all on credit cards. He doesn’t know how to budget. He is completely lost, but wants to change his life.

I would help Johnny learn how to get his spending under control and setup a budget. The end goal would be to walk Johnny through the entire process and eventually have he and his family be debt free.

I’m offering this service free of charge.

I also must include this stipulation: I am not a paid professional, nor am I offering legally binding advice or services. I do love to budget and teach others how, so this needs to be seen simply as tips. If you must, always consult with your accountant/financial advisor before making any decisions based on what I tell you. I’m just a blogger. I might consider phone conversations to provide tips, but e-mail would probably work best. With your permission, I would blog about your travel out of debt (protecting your personal information, of course).

If you are interested in getting out of debt, I’d be happy to help. Leave a comment, or contact me. The e-mail address is on the About page.

This is the sixth post in a series: The No Debt Plan.

Today we continue along the path to financial freedom. If you’ve made it this far, you should have a budget. Thanks to that budget, you’ve also achieved free cash flow.

Let’s put that cash flow to work.

Dave Ramsey recommends readers to save up $1,000 in an emergency fund, then knock out all debt, then finish saving up to 3 to 6 months worth of expenses.

Maybe that works for you, maybe it doesn’t. Let’s define an emergency fund first.

A Proper Emergency Fund

For Emergencies Only

An emergency fund is just that — a fund of money you have saved away specifically for unexpected, emergency situations. It isn’t to be used unless you absolutely cannot cover the expense in any way. Only true emergencies count — not having enough money to buy that new cell phone does not constitute an emergency.

Easily Accessible

You need ready, easy access to this money as well. I highly recommend you get an online savings account with one of the major players. We use ING Direct and it has worked fabulously.

I do not recommend you stuff it away in a CD. CDs do earn higher interest (usually) than savings account. However, the amount of extra interest is usually nominal. Additionally, if you have to pull the money out of the CD prematurely (before it matures), you lose most or all of the interest you’ve accrued. CDs are considered a “liquid” investment, but for our purposes it is not quite liquid enough.

If you’ve got the money sitting in an online savings account, you earn interest for every day it’s in the account. Pull it out today to pay that ER visit and you don’t sacrifice the last few months worth of interest.

Still Earns a Return

Technically you could leave your emergency fund stuffed between your mattress and box spring. That would be extremely liquid, even to the point that I could steal it from you if I knew where you kept it.

The major problem with the mattress plan or anything similar — think a regular checking account that earns no interest — is the money will lose its value over time to inflation.

This is not the time for a full blown economics lesson, but here’s how inflation hurts you. You start the year off with a dollar under your mattress. The cost of living goes up 4% throughout the year. At the end of the year, you still have that wrinkled George Washington waiting in the wings. But good old George only buys you 96% of what it did the year before. Continue on for several years and that dollar isn’t worth close to a dollar.

Hopefully your emergency fund is more than a dollar. This amplifies the point. Your stash of many dollars won’t be worth as much at the end of the year. So it’s best to earn as much reasonable, safe return as you can with the emergency fund… while also keeping it liquid. That’s why ING is such a great deal. I can transfer money in and out of the account, and as it stands today, still earn 3% on my money.

Of course I’ll pay taxes on that 3% interest, so if inflation really is 4% I am still missing out. But I’m doing better than just sitting on the money at home.

How Much Do You Need Saved?

Unlike Ramsey, I’m not going to put a dollar or monthly figure next to what I think you should have for an emergency fund. Climbing out of debt is of the utmost importance, but you do need some money set aside for the inevitable moments of life.

To steal a line from JD, do what works for you. If you are comfortable with $500 as an emergency fund use that as your benchmark. If you are extremely conservative then six months may be for you. We personally target 3-6 months of expenses. Six months would be great, but it is going to take us time to get there. If you are stuck in debt, I would encourage you to save up a little and then keep plowing the rest of the money toward the debt.

What do I do?

We’re currently at about two months. The upcoming government giveaway of $1,200 ($600 + $600) will bolster this up to three months. On top of that I should be getting a bonus from work which will add another half month or so to the fund. Once we are there we’ll feel pretty comfortable. If we had an extreme emergency come up, we could cut off our Roth IRA contributions and extra mortgage payments. For now, slow and steady gets it done. We’ll build up our fund over time without jeopardizing our other goals.

How are you progressing?

As mentioned at the beginning of this article, this is the sixth post in a series called The No Debt Plan. Where do you currently sit on the plan? Have you made it to the emergency fund yet?

Pre-Steps:

• #1 - An Honest, Positive Attitude
• #2 - A Long Term View
• #3 - Goals

Steps:

• #1 - A Budget
• #2 - Achieve Free Cash Flow
• #3 - An Emergency Fund

This is the fifth post in a series: The No Debt Plan.

You just set up your budget. Let’s take a look at it. Where do you currently stand? Do you have money left at the end of the month, or are you going deeper in debt?

This concept is called free cash flow. If your cash flow at the end of the month is negative, you are just digging a deeper debt hole. If your cash flow is positive at the end of the month, then you are accumulating savings or cash. I found two business related visuals that go with this, but I don’t have the rights to them. Instead, here are links to business examples of positive cash flow and negative cash flow. And yes, you might consider running your life like a business. The concepts work exactly the same in this case.

We call it free cash flow because cash ‘flows’ from the top (income) down through expenses and hopefully into your pocket. Even $1 of positive free cash flow is something to be celebrated.

If You Have Positive Cash Flow…

Even if it only that measly little dollar, positive cash flow is where you want to be. If this is your current situation, congratulations. You are well on your way. Even if you are deep in debt, your positive cash flow can begin to chip away at the debt. For starters, you need to build up an emergency fund. We’ll talk about that next time.

Again, positive free cash flow means that you have cash left at the end of the month. You can put that cash to work in whatever way is necessary — savings, debt repayment, or investment. Strive to continue having this each month.

If You Have Negative Cash Flow…

Simply put this means you have no money left over at the end of the month, plus some additional debt. You have somehow found a way not to default on your debt, but you had to borrow more money to make it through the month.

I have some bad news for you. If you don’t do something to change the situation, you will eventually end up bankrupt. That is simply mathematical fact — after a certain period of time, you won’t be able to borrow your way out of debt. It will end somewhere.

You don’t want that. I don’t want that for you. So how do change your situation? I can’t do it for you, but here are suggestions:

• Cut everything you are spending money on out of your life. Of course you can’t cut literally everything, but this is what psychologists tell us the average human needs: shelter, food, water. That’s it. The basic necessities.
  • Shelter doesn’t mean…
    • A $500,000 house on a $50,000 income. Sell, and rent an apartment.
    • Keeping the thermostat at 77 degrees in the winter and 65 degrees in the summer. Lower the temperature in the winter, raise it in the summer.
    • A house, apartment, or condo full of nice things. Sell your HDTV, cancel your cable.
    • Cut everything that costs you a monthly fee unless it is absolutely necessary.
  • Food doesn’t mean…
    • Filet mignon at the fancy restaurants every weekend. It doesn’t mean elaborate meals at home every week. Cut your lifestyle, eat simple. Bread, peanut butter, jelly and some fruit should work just fine.
  • Water doesn’t mean…
    • Beer, soda, or even orange juice in the fridge. Water comes from the tap, you can filter it if you must. It is extremely cheap. Don’t buy expensive bottled water, either.
• Alternatively, you can earn more income.
  • Do anything you can to earn more money as long as it is legal. There are millions of ideas out there, so I won’t go into them here. Even if you had to bag groceries at a grocery store, or sweep floors at a factory, it is worth it. Remember, you have to get to positive free cash flow as soon as possible.

This may seem extreme, but I hope it opens your eyes. You cannot maintain negative cash flow indefinitely. It is only a matter of time before you can’t pay any of your bills. Make a change today. Get on the road to financial freedom. Cut some expenses. Get a part-time job. Get going!

This is the fourth post in a series: The No Debt Plan.

I have been afraid of writing this post for some time. Out of anything I will ever write on this blog, this is by far near the top of the list of the most important topics. To succeed in your financial life, to run your No Debt Plan, to really understand what is going on… you must be able to budget. There is no alternative. Call it a spending or savings plan if you like, when it comes down to it they are all the same — a budget.

Definition

From Webster’s Dictionary:

4 a: a statement of the financial position of an administration for a definite period of time based on estimates of expenditures during the period and proposals for financing them; b: a plan for the coordination of resources and expenditures; c: the amount of money that is available for, required for, or assigned to a particular purpose

Whew! Quite the mouthful.

I define slightly differently. A budget is a tool that

• lets you see where your money is coming from, and
• lets you tell it where to go

I think that last little bit is especially important. A budget doesn’t tell you where your money went. Your money shouldn’t be going anywhere without you knowing about it. It does show you were you told it to go.

The Pieces of a Budget

Your budget will have three main pieces - income, expenses, and free cash flow. Hopefully income is greater than expenses. This leads to free cash flow. I’ll talk more on understanding free cash flow in the future, but essentially it is what is left after expenses are deducted from income. If everything is going well, it is a positive number. If you are spending more than you are earning, it is a negative number.

Income is simply any money you bring in during the month. We typically only count income from jobs in this category. We use gifts, rebates, or money made selling personal possessions differently. Expenses are the things you spend your money on. Rent, utilities, food, gasoline, debt minimum payments, and car payments are all examples of an expense.

Where to Start

The budgeting process can be very eye opening. If you are sitting at your computer reading this and you have no idea where your money goes each month, a budget will solve that very quickly. Again, the goal is not where to see where your money is going, but for you to tell it where to go. But! If you don’t even know where it is going, a budget will do that too.

So, where do you start? Let’s just start at the top of the list above: income. Where is your money coming in from, when does it go in your account, and how much is it. For most people this should be pretty simple with just one job. Total the amount of money you expect to bring in every month, especially this month. Precise numbers are better than generalities, but anything will do at this point.

Next up are your expenses. This can be where the headache starts, so try not to get discouraged. A lot of data is involved because you aren’t normally spending all of your money in one location (unlike income, which is usually just one or two sources). To get this data, look at your bank accounts and credit card activity statements. This should cover most everything. The bank accounts will cover cash withdrawals as well as debit card use. Credit cards will show you each location you are spending money. Figure out what category each purchase is in. Sometimes you just have to pick one category if it is mixed.

Now compare the two categories. If your income is $3,000 after taxes, and your expenses are $3,400… you are in the hole. If expenses are $2,900 you have some breathing room. Either way, you now know where you stand. Now what?

Tell Your Money Where To Go

Line up all of your expenses and determine how much you should be spending on them. Make a list of expense categories. Put what you normally spend next to the category name. Now, determine where you can cut back. This is where you are telling your money where to go. Commit to spend only $300 on groceries this month and don’t allow yourself to eat out. Call your cable company to reduce your cable package. Cancel that gym membership.

Once you make your adjustments, look at the bottom line. How much extra money could you save if you implemented your changes? This is money that can be applied to debt (and later in the process, for savings). Remember, you don’t necessarily need to earn extra income if you can commit to just cutting back.

This is a huge step and it does require some work. You aren’t going to find yourself debt-free in the future without doing some work. Later on in the process I’ll share some tools you can use to help set up a budget.

This is the third post in a series: The No Debt Plan.

A key step to getting yourself out of debt is to see the light at the end of the tunnel. You need something to motivate you along the way. Something to track and chart. A little thing to remind you of why you are sacrificing and living the frugal lifestyle.

Of course, those little things are goals.

Goals help you see past the day to day issues you face on your path out of debt. For goals to be useful, there are some stipulations. Those stipulations are called S.M.A.R.T. goals.

S.M.A.R.T. stands for specific, measurable, attainable, realistic, and timely. These are all sort of interlinked together.

• Specific means the goal is not general. In terms of debt, a general goal would be “To become debt free” or “Pay off my credit cards”. A specific goal tells, as you would imagine, a lot of specifics. “To pay $25 extra principle on all three of my credit cards” is a specific goal.
• Measurable means the goal can be counted or progress can be tracked. “Save money” is not measurable. “Save $25″ is measurable; you can tell whether or not you saved $25.
• Attainable and Realistic means you can actually achieve the goal. It is realistic, although challenging. This is very important as you tackle debt. If I am $25,000 in debt, and my goal is to have $1,000,000 in my savings account one year from now… well, let’s just say that is a nice goal. It is not realistic.
• Timely means there a time factor associated with the goal. Again, a goal such as “get out of debt” or “save $1,000,000″ does not have a date associated with it. You are much less likely to achieve the goal if there isn’t a time associated with it. Placing a date at the of the goal, no matter how far away, means you will be more likely to hit it.

So what are some solid, SMART goals? (Note: these aren’t our actual goals.)

• To pay off the 16% interest credit card by August 1, 2008.
• To save $300 per month towards our emergency fund for the first six months of the year.
• To save $2,500,000 for retirement by age 58.
• To pay off our home mortgage by April 2015.

The list could go on forever. I encourage you to try using SMART goals in your life.

So you’ve decided you can have an Honest and Positive Attitude for your No Debt Plan? Time for Pre-Step #2 - a Long Term View.

True enough, getting into debt can seem relatively easy. It can be. Yet you probably didn’t get yourself into this situation yesterday.

Along the same lines, you most likely won’t be able to fix this overnight. If you just created this problem yesterday, you could make some drastic choices and get out of it tomorrow. For those of you that are seriously in debt, this is going to take a while.

Remember, we’re being honest and positive. This all sounds brutally honest, and it is. How can it be positive?

I think the positive part is that you are seeing the light at the end of the tunnel. It may be the size of a pinhole and be six years away, but it is there nonetheless. When you have debt piled up to your eyeballs, it may seem you will never get out. Being able to see the end of the tunnel no matter how far away is a serious change of view.

We’ll talk about this in the next section, but having goals will help you clarify how long this trip is going to take you. Once you know where you are going, you can get on your way. Six years may seem like a long time from now, but imagine the years after that without that debt cloud hanging above your head!

This post kicks off a series that will develop my plan for getting you out of debt. This may seem an odd topic for me to tackle; the only debt we hold are student loans that are in deferral. Yet I have read, seen, and heard the damage debt can do to individuals and couples. I hope you can take a small piece of everything I write with you on your way to the land of no debt.

Before we can talk about budgets, interest rates, credit cards, frugality, or retirement… we must discuss attitude.

A negative attitude will severely hinder your attempts to climb out of debt. Why? Getting out of debt isn’t a cakewalk! They are going to be hurdles and stumbles as you climb out. You can view each of those challenges in one of two ways: positively or negatively.

If you run into an obstacle, a negative attitude will just slow you down in overcoming it. It is a true momentum killer. You have to stay focused on the end goal: getting out of debt.

Second to a positive attitude is an honest attitude. You can’t play games with yourself. Take a good, hard, honest look at your situation. Face the music. Look at everything in your situation — not just some of the pieces. Do you have a negative cash flow at the end of every month? Do you know how much you spend each weekend going out to dinner and drinks with friends?

It isn’t hard to take an honest look at the data — credit card companies and banks send you statements. You should be able to decipher from these where your money goes each month. The data is there. The only thing stopping you is you.

So be positive, take your lumps when they come, and be honest with yourself. Do that, and you are well on your way to reaching any goal — especially getting out of debt.