No Debt Plan

No Debt Plan is a blog about living a debt-free life. If you're new here, you may want to subscribe to my RSS feed (e-mail subscription also available). Learn more about me, or some of my most popular posts. Thanks for visiting!

One of my good buddies, Michael, asked me a question online the other day. He mentioned he really enjoyed the “Only Buy Appreciating Assets on Credit” and “Credit Cards and Depreciating Assets Don’t Mix” posts. To summarize these posts I said a major problem with credit cards is people use them to buy assets that are worth less the day after they buy them, rather than worth more. An example is buying a plasma TV that you pay $1,800 for and 6 months later it is worth $1,200. That’s just silly.

However, he did have a question that will help me clarify the issue.

I loved your appreciating assets post. However, I had a question about using credit cards. If I use my credit card to buy groceries and gasoline, but pay it off at the end of every month, is that okay?

I have long been a proponent of using credit cards to simplify your financial life (one payment vs. several) and to earn cash back (or other rewards) for every day spending.

I did not make that clear in the two posts referenced above.

So, to clarify. When I say don’t buy depreciating assets on credit what I mean is don’t finance depreciating assets on credit. I define financing as carrying the balance on the credit card and paying interest/finance charges for the item. If you pay off your balance at the end of every month — and thus enjoy rewards without penalties — then go for it.

I recently received a comment on my post 10 Steps to Avoid Becoming a Millionaire.

Why is it that some people seem to think money just falls out of the sky. I take 3% for my 401K and it’s magic! Another 3% materializes out of thin air and the electric bill still gets paid.

I have news for you. Sometimes the salary you get covers things like rent, food, electric, water, clothes, groceries, medical bills, etc etc and sometimes there really isn’t 3% left over at the end of the month. Sometimes there isn’t even 1%.

Now I would really like to espouse that old “pay yourself first” thing I’ve heard, but there is something interesting there. What’s interesting is that I don’t send myself a cutoff if I miss the electric bill, I don’t send myself an eviction notice if I don’t pay myself the rent.

Some of us don’t have a pot to piss in or a window to throw it out of and whether you believe it or not, it can really not be from lack of trying or failure to relocate or some other cockamammy reason that’s always given for being poor. So cut us some slack, OK? Not everyone can “afford” to save or invest and we’re getting damn tired of other people acting like that’s a moral failure!

Now, for my response.

Kelly, I am sorry to see you have taken offense to the article. I’m open to discussion and appreciate you stopping by.

The simple fact that sometimes there isn’t 3% or 1% left over at the end of the month indicates to me that that person is not spending less than they earn. If your expenses are right up next to your income, you’ve got a problem. You probably know this, but maybe don’t know how to fix the situation.

You have two choices in this situation — spend less money, or earn more income. Spending less money is usually easiest as most Americans live a life of relative luxury compared to other countries and to previous generations.

That may sound ridiculous and over the top and that’s okay. Some of you will disagree with it and there are exceptions to every rule. But do you have a cell phone? Home internet? What cable plan are you on? These are three quick hits to cutting down on your budget that could save you at least $100-150 each month depending on your service levels. If “But I can’t live without a cell phone or TV!” is your response, well there’s the problem and why you have no money left at the end of the month.

Starting with those monthly plans is a great way to cut money. I’m not saying it will be pleasant by any means. Life without a cell phone or internet at home would not be enjoyable for me. Those communication devices are awesome. However, if you are just treading water with your finances — or worse, you are under water — it might be a necessary step.

Budgeting is another key factor to controlling your money (rather than it controlling you). It absolutely changed our financial life. It’s step one of my No Debt Plan. Sitting down and figuring out where you have spent your money each month for the last month or two can very eye opening (what do you mean we spent $300 eating out!).

And if you haven’t been inspired enough, Get Rich Slowly tells us the story of Crissy Thompson, “The Coupon Queen.” She pays around $10/month for groceries for a family of five. Legally. By using coupons. It takes a ton of work, but if you could save $200 per month on groceries that’s a huge impact!

As I mentioned, there is another way. Perhaps you have cut your budget to the bone. There is no wiggle room left. Your only other option is to make more money. Get a second job. Work on the weekend. Find ways to earn alternative income. In the past month and a week, I’ve earned over $400 blogging online (not on this site, on others). That’s not going to pay off the mortgage tomorrow, but it isn’t exactly chump change either. If I were in a desperate situation I would find a way to work at least 10 hours on the weekend, even if it was at $7/hour. That’s an extra $52.50 each week after taxes (assuming a 25% tax bracket). For a four week month that would be an extra $210 to apply to debt, build up savings, or to invest. It might not be much, but it could keep your head above water.

Obviously my original post about how to not become a millionaire took a reverse look at things. Saving 3% of your income may be a big milestone to you, so make it a goal and strive for it. Take some of the steps above, and see where you land in a few months.

I received a comment recently on the article where I asked How Much House Do You Buy Each Month? Nuggie asked,

How does escrow fit in, and does it ever make sense to prepay escrow?

Here’s a brief overview of escrow in relation to a home mortgage. (You can also get the general idea from Lending Tree’s information on escrow. The following is just my opinion.)

A quick explanation of escrow

Escrow is an account that the mortgage company opens up for you to hold onto different monies. Your homeowners insurance and property taxes are the most common uses for escrow. Part of your monthly payment includes your escrow monies. That means the mortgage company is holding onto your money to insure that you pay your property taxes and homeowners insurance. In fact, they pay them for you.

Why does the bank hold onto escrow for me?

The bank has a vested interest in the house. They require you to have insurance so that if it burns down, you can pay back the money they lent you. They require you to pay your property taxes so that your state/local government can’t take the house from you. That makes sense from a business perspective. I’m not going to lend a few hundred thousand dollars out to someone if I can’t be reasonably sure I will either get the money back or get the asset into my ownership.

Should I ever prepay escrow?

There are not many situations I can dream up where you would want to prepay your escrow. I do know that our mortgage holder, Suntrust Mortgage, gives us the option to apply any additional payment to escrow. As we discussed, escrow payments are based off of your insurance and property tax costs. This should stay fairly consistent year to year. However, a new tax assessment or perhaps upping the coverage on your house could increase either of the underlying costs behind escrow payments.

Your bank may also only make adjustments once per year. Our taxes should be lower than what we are paying into escrow because we were able to homestead our home here in Alabama. But Suntrust told us they only adjust the escrow payment for taxes once per year. If you were going the opposite direction — higher costs — then you might want to start paying extra each month so you don’t end up owing a large amount to your escrow account at the end of the year.

(Photo: Mill Street by Paul Keleher)

Have a question? Don’t be afraid to ask! I love to help clear up concepts or issues for readers. Or feel free to bash me. Whatever feels right. Drop me a line, or leave a comment on a post.

I received a reader comment a few days ago asking me to address an issue.

I was thinking about this: our closing date is 10 days away and I’m starting to panic about the whole 30 years of debt in the middle our our sucky economy. Will you write a piece about how you felt when you signed the deed of trust and in the days before and after?

Alright, so your closing date is now 9 days away. By the way you wrote your statements, I’m guessing this is also your first house.

I’ll do my best to describe all of the emotion and feeling that went into buying our first house last fall, but I’m not sure I’ll do it justice.

For starters, don’t panic. Panic and worry will only encourage you to start thinking irrationally. You’ve also probably got some money in the deal that you won’t be able to get back at this point, so backing out due to panic and fear doesn’t make sense either. Granted, if you suddenly re-ran your numbers and discovered you won’t be able to make your first mortgage payment then by all means back out.

This highlights the key of planning. Are you using a budget? Did you run a guestimate of how much it would cost to operate a house over an apartment? Do you know how much cash flow you have at the end of each month? If you did, and I hope you did, then great. All you have to do is go back and look at the numbers.

It is an extremely scary decision when we signed the initial contract. Closing was also a bit nerve wracking. I would go as far as to say it was very surreal. There was a big stack of papers, but our closing went very smoothly. Everyone there was very helpful and patient — we read a lot of what we were signing. Note I didn’t say we read everything. You really should read every line, but there are some things we just glanced over because we had either read them ahead of time, or since we had two mortgages we signed two versions of essentially the same paper.

It was also kind of odd because our real estate agent and the home builder’s agent were there. They didn’t seem to do a whole lot other than sit there. I don’t think we asked either of them a question. Moral support?

When we walked out it was just weird. One of those “Did we just do that?” type feelings. However, we had run the numbers and were getting a house well within our means. We didn’t buy a 5,000 square foot mansion; we knew we could afford to pay (and even pay principle faster than normal).

As to buying in a recession, I would again point you back to your data. I won’t say there is no better time to buy a house — it depends on your area and in three more months prices may have dropped again. But, generally speaking, you are definitely not buying at the top of the bubble. If this home is truly within your means, you shouldn’t have a problem.

Some questions I would be asking myself right now:

1. Did we go over a budget? Is it still accurate? (Much can change in your life between when you sign the contract and when you close.)
2. How much wiggle room do we have budgeted each month?
3. Did we estimate all of our housing costs (moving, utilities going up, insurance, taxes, etc.) correctly?
4. Is my job stable? Am I likely to lose it and be unable to find similar work?
5. Do I have an emergency fund? If so, how big is it? (Six months of living expenses — at your new living expense level — should go a long way in helping you feel better. If you don’t have it, even a small one will do.)
6. Are we staying here long term?

Hopefully you did a budget, the house payment is well within your means, you’ve got some wiggle room, we estimated new costs correctly, you’ve got a stable job, you plan on staying long term, and you’ve got an emergency fund!

I received an e-mail from a reader with a question. I told him I would answer on here to open up the discussion to anyone else that wanted to bring in some input. This post is rather long, but hopefully there are some advice that is useful to you.

I have been following your blog and I have a question about one particular item that I have not seen you discuss.

How do you and your wife prepare for major purchases that you know are unavoidable?

Obviously you have an emergency fund for things that come up that you do not expect. But what are you currently doing for the things that you do expect?

The main item in question for me is cars. I know that my vehicle will not last forever, and I know what my plan is for replacing them someday. But I am just curious what your plan for that is. I will share my plan. It is Dave Ramsey’s idea, but I think it is a good one. Basically you invest the equivalent of a car payment into a good mutual fund for 5 years.

After that first 5 years there is enough money in that fund to pay cash for a good slightly used car, plus enough money left in there that will continue to accrue enough interest that you will never have to put any more money in it. Meaning that every 5-7 years the fund will have earned enough interest to pay again for a good used car. The only modification I plan to make is to put the money I get from selling my current car back into the fund. I believe this will allow me to upgrade every 5-7 years as well.

All this is to ask:

1. Do you think this is a good plan?
2. Do you currently have a plan in place?
3. And if you don’t think this is a good plan what would you recommend?

So, a lot to tackle here. Let’s break it down.

For expenses that are unknown, the reader is right. We have an emergency fund for unexpected costs (water heater exploding, flat tire, car/house insurance deductibles, etc.).

For anticipated expenses that are down the road, we try to budget it out as reasonably as possible. Are we currently saving for our next cars? No, but they are on the list. Here’s some examples:

• Saving for a ‘new’ used car - we would like to get to the point that we are consistently saving for this, even if it were $100 per month. Every little bit counts. Saving a full car payment depends on what your idea of a car payment is.
• Saving for new tires for our cars - I think it would be a bit overboard to save up a specific amount each month for new tires right when you buy a new pair. If our monthly cash flow is healthy, I may just eat the cost of tires in the month it happens. If not, we may spread the cost out over a couple of months. If I see the tires are wearing down and I can plan for it, I would share the cost over several months.

In regards to Dave Ramsey’s plan, this is how I understood it. Assume you have a car payment of $350. You pay off the car this month. This should leave you $350 next month to do as you please. Dave’s advice is to continue to save that amount every month, just like you had a constant car payment. When the time comes to sell your car, you’ll have enough cash on hand to purchase a new used one… and restart the cycle. That’s the plan I’ve heard.

As to the plan that was mentioned by the reader, I am a bit skeptical. Let’s run the math (link to Excel sheet I created). If you pay $350 per month to yourself and earn 0.67% growth per month after fees and taxes (8% per year / 12 months = 0.67%). Pay the $350 for 60 months, and you should have $25,888.35. Let’s take out $15,000 for a used car, leaving you with $10,888.35. (Of course, you would add the selling price of your previous car to that $15k as well, so you might not need the full $15k.) That principle is going to have to grow over the next five years to not only pay for the next used car, but also keep funding itself to buy the car after that. Running the math, the likelihood of that happening looks slim to none. It would work to buy the first and second car, though.

If you bump it out to seven years of payments and seven years between cars, the math is a lot more promising. It looks like you could pull it off. Really, in the end, if you have enough in an account that earns a consistent return, you would be able to estimate what your ‘income’ off of the fund would be. If that amount over your specific period of time is greater than the cost of a new used vehicle, then you’re golden.

However, you can only crunch numbers for so long before it starts getting really complex. You can’t factor in for issues like investment loss (or lower growth), inflation, taxes, or the value of the car you would sell. Well, you could, but it would be complex!

I would always be cautious in putting money into an account that I am going to need within a short time frame. I think five years is a relatively short period of time compared to retirement. Imagine putting your money into the mutual fund in 1999 and watching it lose a large amount of its value over the next few years. If you had to buy a car in 2001, you would be in some pain. If the money was in a more safe vehicle (bonds or a high yield savings account), I would be more comfortable, but then you are giving up possible investment growth (difference between what it could have grown and the yield on the account).

To answer the questions above:

1. Do you think this is a good plan? - I think it can work. It might be a little too risky for my blood. I would prefer a savings account for liquidity purposes. As JD at GetRichSlowly likes to say, “Do what works for you.”
2. Do you currently have a plan in place? - Actually, no. (Gasp!) Saving for a new car is on our savings snowball list (more on that later), but we are focusing on funding our NYC trip, emergency fund, MBA debt in deferral, and Roth IRAs currently.
3. And if you don’t think this is a good plan what would you recommend? Again, do what works for you. I don’t think it is necessarily a bad plan. It really depends on the cost of the ‘new’ vehicle, how much your investments really return, and a ton of other factors. The bottom line is awareness is a big step forward in this arena. Simply knowing that a car is going to be need to be replaced ahead of time puts you a step ahead in the game.