How to Get Out of Debt and Save Money
Mark Vakkur, MD
See also: Mind Over Money - How to Put Behavioral Finance Principles To Work for You
How to Save $500- $1,000 a month painlessly
Behavioral Finance Summary
Money may not guarantee happiness, but absence of money can lead to misery. Finances are a major cause of marital strife. It is impossible to quantify, but anxiety from financial insecurity maybe a major source of psychiatric morbidity. High consumption, low savings, and poor money management translates into working harder and longer for less.
Consider the following bad news:
- the average American household spends 22% of all disposable income on debt payment (versus only 5% in Scandinavia) (Barrons, 11/15/04);
- personal bankruptcies surged from 800,000 in 1994 to 1,410,000l in 1998;
- our economy is heavily dependent upon low savings and high spending; consumption constitutes 70% of United States Gross Domestic Product;
- the median net worth of United States households in 1998 was $60,700 only $2,300 higher than in 1989 per the Federal Reserve's 1998 Survey Of Consumer Finances;
- excluding home equity, the median financial net worth was only $17,800Ö [source]
But here's the good news:
- the average American household will earn a million dollars every couple decades;
- making even small daily decisions about how those millions flowing through the home are spent and invested can translate into dramatic dramatic differences in net worth, lifestyle, and security.
Compiled here are a few tips to help decrease monetary anxiety.
Pay yourself first. The first check you write each month should be to yourself. Fully fund your 401-k, IRA, or retirement plan FIRST, then pay off your highest after-tax interest rate debt (if applicable). A good savings target is 10%. Consider this: no matter how much you make, if you save 10% of your income and invest it at 10% a year, you will be earning as much from your investments as from your work in only 25 years. This does not take into account raises or increases in pay which would shorten this time. 25 years may sound like a long time, but it means that a 21 year-old college graduate could potentially retire at age 46!
Simplify your life. Because of taxes, reducing unnecessary expenses has a much more powerful impact on your financial health than boosting your income. For someone in the 28% federal tax bracket, reducing expenses by $390 is equivalent to earning an extra $500. The lower your "burn rate", the less money you must generate from your investments to maintain your lifestyle, so the less you must save to achieve financial independence.
Don't pay a premium for commodities. If a low cost or no cost choice exists, take advantage of it. Visit your library - you can keep your books, videos, and DVDs longer with no rental fees (and much less punitive late fines). It's the same movie whether you pay for it or borrow it. A car is just a car; sinking $70,000 into a depreciating asset is equivalent to emptying the contents of your wallet onto the parking deck of your workplace every day. Long after the new car smell is gone, the debt or lease payments remain. Most luxury cars have lower-price substitutes, often with the same chassis and engine, sometimes manufactured in the same factory! Brew your own coffee and drive past Starbucks (in your hybrid car).
Brown bag it. Many Americans will drive across town to save $50, but they would be much better off saving $5 a day on lunch. (equivalent to $1,250 a year before taxes (assuming 250 working days a year), or almost $1,865 for someone in the combined federal and state 33% tax bracket). As a general principle, saving $1 each working day is much more powerful than one-time savings (250 times as powerful for the average worker).
Lose the SUV. Environmental and safety reasons aside (roll-overs were a leading cause of death for SUV drivers), paying a premium for a gas-guzzling vehicle makes little sense. Gasoline remains very cheap (as of 2005) by historical, inflation-adjusted standards, but even a small spike in energy prices could lead to wild fluctuations in monthly outflows for the average American family. Consider also the effect such a spike would have on the resale value of all those SUV's unloaded on the market by their drivers coming to the same realization at the same time.
Pay off your credit cards today. Borrow this money if you have to! With interest rates relatively low, there is absolutely no reason for anyone to be paying 18 to 21% on credit card debt. If you make only the minimum payment each month, you will pay many times more in interest than what you originally charged. If you carry a $5,000 balance on a 21% VISA, you are paying $88 a month in interest. Since these are after-tax dollars, you must earn $112 to pay this amount. Thatís $1,344 a year! Remember, this is just the INTEREST! For that money, you could go on a one week cruise.
Here are some ideas:
- Take out a line of credit against your home for the amount of your credit card debt. Since the bankers have your home as collateral, the interest rate is generally much lower. And since the interest on the mortgage is tax deductible, you can multiply it times (1 - your tax rate) to get your effective after tax APR. In other words, if you are in the 28% tax bracket, a 12% home equity line is only 8.6% ( (1 - .28) x 12% = 8.6% ). In the example above, the interest burden would decrease from $88 to about $36 (after taxes), saving you over $50 a month. Shop around for the best rates and terms.
- If you own a car, a computer, or anything of value, go down to your bank or local credit union and ask for a "chattel mortgage." This is a loan using the item you own as collateral. The advantage, once again, is that the interest rate is generally lower since your car (or whatever) is being offered as collateral. (A credit card is an "unsecured" line of credit, meaning that it is simply based on your word that you will repay it, which is worth very little to your bank. This is the reason they give to justify their high interest.)
- If you own stocks, but donít want to sell them, take out a margin loan against your stocks. For example, if you own $10,000 worth of stocks, you can write a check for $5,000 (50% of the value of your stocks) out of your account. Make sure you have a margin account set up before you do this, and always confirm that you have sufficient equity. Normally, buying stocks on margin is a risky proposition, but if you have credit card debt and own stocks you have already in effect bought the stocks on margin. The big advantage to margin interest: itís fully tax deductible against any capital gains. Also, the interest on a margin loan is about half of that on a credit card because - you guessed it - the loan is secured with the value of your stocks.
- Sign up for another credit card with an introductory teaser rate of 5.9% or lower, then switch your balance to this lower interest card. Promise yourself to pay off the balance over the next 6 months (before the APR jumps). If this is not possible, get a third card and start the clock over again. Most of us get at least one offer a week for a credit card with a low introductory rate. (The key is to remember to pay off your debt before the rate goes up.)
- Call your current credit card company and ask for a lower rate. Have at least one competing offer in hand before making this call. Seriously! The credit card business is an extremely lucrative and competitive one; they need you more than you need them. Most credit card companies have a "retention department" and will gladly adjust your rates to keep your business. Another thing: demand they drop any annual fees, membership dues, or other such nonsense. They are already robbing you with usurious rates; you shouldnít have to pay for the privilege of having your pockets picked! Believe it or not, most credit card companies will drop those fees if you ask them to (which makes you wonder why they charge them in the first place).
- Open an overdraft line of credit at your bank and use this to pay off your credit card (assuming you can get a lower interest rate).
- Borrow the money from a friend or relative. Work out a repayment schedule and put it in writing. Unless you are a poor judge of character, your friends should not charge you anything close to what your credit card company does.
However you do it, once you pay off your credit card, PROMISE YOURSELF NEVER TO CARRY A BALANCE AGAIN except in dire emergencies (such as following a job loss or late paycheck deposit). Some people may not have the discipline to carry credit cards (a fact the credit card companies depend upon for their profits); if this is true for you, consider tearing yours up, or hiding it in a secure location only for emergencies.
Consider adopting a cash-based budget: If you can't resist the urge to splurge, leave your plastic at home. At the beginning of each month, figure out how much you will have left after paying all your bills and saving 10% of your income (or using it for debt reduction). Divide this amount by 4.3. This is your weekly allowance. Round it down to the nearest $10, and withdraw it every Monday from your ATM. If you run out of cash, stop spending. That's it - no budgeting, receipts, spreadsheets or reconciling. The number of George Washingtons staring back at you from your wallet is your budget! It's simple, visual, and fool-proof.
Behavioral finance studies indicate people spend much more when they can pay with credit card than they do if they can pay with check, but cash trumps all forms of payments. When those little green pieces of paper leave your fingers, you know they are gone forever. Signing a credit slip never gives you that sense of finality. Put this principle to work and simplify your financial life for good!
Wherever possible, buy, don't rent or lease! This applies most dramatically to housing, but can also be used as a general rule for anything that you plan to keep more than a weekend. Renting furniture, television sets, phones from the phone company, or leasing your car can end up costing you far more than what the items are worth. For example, if your phone company charges you $15 a month to rent a phone, after a year, you have in effect bought a $150 phone and have nothing to show for it (itís still the phone companyís property). Rent for a decade, and youíve spent $1,500 for the phone - that must be some phone!
Car leasing is little better. An entire industry has been built around the lease-versus-buy decision, but as a general rule, unless you have a compulsion to drive luxury cars you really canít afford (otherwise why not buy them?) and have to have a new car every 3 years, buying a sensible car and replacing it in a decade will cost far less (see below). Some business expense exceptions may apply - check with your accountant or financial adviser - but for most of us, minimizing the cost of our transportation puts tens of thousands of extra dollars in our pockets every few years.
Always consider the total cost of something, not the payments you must make. Don't fall for the trap of paying much more long term to avoid short term cash flow problems. Getting a floating rate, interest only mortgage may seem like a smart idea for the next year or two, but how much will it cost over the life of your home? How much money will end up in your banker's pocket and how much in yours? Most leases are sold based on lower monthly payments, but over the life of most vehicles, you are much better off buying them outright.
View debt pay-off as an investment with a high, guaranteed, after-tax rate of return. Let's say you get a $1,000 bonus to invest and owe $1,000 on an 8% car loan. You are wondering whether to invest the money in the stock market or pay off the car loan. How much would you have to earn in the stock market (after taxes) to beat the "guaranteed" 8% return by paying off the loan? Answer: even if you paid only 15% on dividends and capital gains, you would still have to earn 9.4% just to equal the 8% car loan "return" on your money. But the stock market return is far from guaranteed, so a risk premium should be demanded. Paying off non-tax-deductible loans almost always trumps investing as a target for your next marginal dollar.
Contribute maximally to any 401-K plan, 403-B plan, or other tax-deferred savings plan offered by your employer; if unavailable, contribute the maximum amount to an Individual Retirement Account. If you qualify, beg, borrow, or steal to get money into a Roth IRA. [More on IRA'sÖ]
Buy a reliable, low maintenance car and promise yourself to own it for 10 years.
Educate yourself about taxes and claim every deduction to which youíre entitled.
Get educated and stay educated. Tax laws and investment options change. Good sources of information include Money magazine, the personal finance section of the Wall Street Journal, and Smart Money. Avoid fads. If it sounds too good to be true, it probably is. Think long-term.
Spend a little less than you make, pay off your debts, then invest the difference wisely. Reduce expenses, simplify your life, work less, live more!
- source: "Net Dearth", edward m. syring, jr., barrons, 5/28/01, page 40. syring = former economist with fed reserve bank of ny
- More on IRA's: Even if youíre in debt, you should do this, even if it means you must pay off your debts more slowly. In fact, if you donít have the money, borrow. This is one of the few instances where it would make sense to get a cash advance on your credit card to finance your investments.
The reason this strategy is so important has to do with taxes. Even if you have a low income, taxes will be the single biggest expense in your life. If you can reduce your taxes by even a modest amount, the payoff over the next few years will be enormous.
Another disadvantage to paying off the credit card early is that once the calendar year ends, you lose that opportunity to contribute forever. For example [note: this example is dated, since the contribution limit has since been raised, but the principle holds true], assuming that your working life spans 40 years, and the maximum contribution you can make to your IRA remains fixed at $2,000, then over your lifetime, you can make $80,000 of contributions. If you fail to invest for the first 10 years, you can only invest $60,000. You canít go back in time once you have the money, but you can always go back and pay your debts off once you have taken full advantage of your retirement plan. Furthermore, contributing $2,000 today will allow that money to compound for five years longer than if you wait half a decade to start your investment program. While this may not sound like much, it can make a dramatic difference in the amount you have saved by retirement. For example, if you start investing in an IRA at age 25 and earn 10% annually for the next 40 years, you will be a millionaire at age 65 - your IRA will be worth $1,054,013. If, however, you wait just five years and donít start investing in your IRA until age 30, you will have $193,956 less at age 65! One way to look at this is that each of those 5 years of waiting cost you $38,791!
Another example to illustrate the tremendous power of compounding over time: if you contribute $2,000 annually to an IRA starting at age 18 and STOP contributing at age 25, you will have MORE money at retirement than someone who started investing at age 26 and contributed every year for the next 40 years. Thatís right - the total of $14,000 invested between ages 18 and 25 would compound to $1,082,479, more than the $1,054,013 that the $80,000 contributed over the next 40 years would grow to! Which path would you choose to becoming a millionaire - one that required $14,000 of your money, or one that required $80,000? Time is far more important to the accumulation of wealth than the total amount invested.