Financial Makeover: Getting Out of Debt

Aug. 18, 2003 -- — Q U E S T I O N: Despite our income, we still live paycheck to paycheck. My husband decided we need to "stimulate the economy" so we bought more things we don't need including three snowmobiles on credit. We have no savings or disposable income. I have a 401(k) plan with very little in it and he has no retirement plan at work. I would like to save more and be able to help our college bound daughter with some of her expenses, but because of the lack of savings, and our inability to hold onto money, I am stuck. Can you help?

— Kathi

A N S W E R:

Kathi is frustrated because she and her husband Curt are living paycheck-to-paycheck despite an income that she feels should allow them to live comfortably and accumulate savings for retirement, their daughter's college education, and other long-term goals. She suspects that they're in this situation because they often make frivolous and expensive impulse purchases, usually using credit cards.

Fortunately for Kathi and Curt, their problem is a lack of saving discipline, not a lack of income. Their $70,000 income is well above the national median income of $43,000, so they are in a good position to save … if they can get their spending under control. Before they can even begin a savings and investment program focused on achieving their long-term financial goals, Kathi and Curt must learn to live within their means.

To make progress toward this first step, Kathi and Curt should do the following:

Define long-term goals: It is very difficult to motivate oneself to save without clear future spending objectives in mind. Kathi indicates that she and Curt want to save for retirement, but I'll bet that, like most people in their 30s, retirement is only a vague notion to them. They probably haven't spent much time thinking about how exactly they want to spend their retirement. By defining specific retirement spending objectives that motivate Kathi and Curt (e.g., retire at age 60 spending $55,000 annually, buy a $150,000 vacation home, etc.), long-term goals become more "real," making it easier for them to defer spending now and save for the future.

Develop a budget: Developing and following a budget is crucial to curbing out of control spending, as it forces people to acknowledge and understand how they're spending money. Budgeting can be as simple as keeping written notes or as complex as using Quicken or a spreadsheet. What's important is that Kathi and Curt find a way of tracking their expenses that works for them.

They should begin by setting reasonable and realistic spending targets for each major expense area (e.g., groceries/dining, vacation/entertainment, utilities, insurance, automobiles, etc.) and setting a monthly savings target (more on this later). They can then observe how their actual spending over the next several months compares to the targets. They'll likely find that their actual spending is far higher than their targeted amounts in several expense categories. Armed with this information, they can then work on adjusting their spending habits to adhere to the spending targets.

Stop using credit cards: The credit card industry is one of the most profitable businesses in America for a reason — it preys on the basic human desire to consume now instead of later. Kathi and Curt have fallen into this trap and as a result have run up credit card balances, probably at very high interest rates. They should immediately stop using credit cards and instead pay for general living expenses with cash, checks, or a debit card. Adhering to this principle will also discipline them to live within their budget and not accumulate additional debt.

The difficult aspect of curbing out-of-control spending is that it requires Kathi and Curt to trim their spending now in order to have more money to spend later in life. The good news is a little discipline goes a long way toward helping them achieve their very important long-term goals. And after awhile they will simply become comfortable living within their means and spending at a lower level. Kathi and Curt should check out Eric Tyson's Personal Finance for Dummies book for many more useful ideas on how to put spending on a diet.

Getting Out of Debt

Before accumulating savings toward their long-term goals, Kathi and Curt need to work on extinguishing any credit card debt, which typically carries high interest rates of 15 percent or greater.

Relocate debt. Since Kathi and Curt own their home, they may be able to obtain a home equity loan and use the proceeds to pay off the high-interest credit cards. Interest rates on home equity loans are generally lower than on credit cards. Moreover, the after-tax cost is almost always less because home equity interest is tax deductible while credit card interest is not. The risk with such loans is that if they fail to make payments, the bank will come after their home, so they should only borrow an amount that they are completely comfortable making payments on. Also, they need to discipline themselves to not use the home equity line as another source of credit for more unnecessary spending!

Refinance debt. If they haven't already done so, Kathi and Curt should look into refinancing their home mortgage. A lower monthly mortgage payment would free up funds to get out of debt faster. Their banker can tell them more about refinancing their mortgage and obtaining a home equity line of credit.

Reduce debt. After income taxes, Kathi and Curt have about $55,000 of disposable income. They don't indicate how much credit card debt they have, but let's assume it's $10,000 on a card that charges 15 percent interest. If Kathi and Curt can trim their spending by $350 per month then they'll repay their entire balance after 2.5 years. They can accelerate this repayment schedule if they transfer the debt to a lower-cost home equity line or credit card, or if they manage to save more than $350 each month. (One tried and true way of increasing one's savings over time is to commit salary raises, bonuses and tax refunds toward savings or debt reduction instead of increased spending.) As a way of disciplining themselves, they should look into creating an automated debt reduction plan by establishing direct electronic payments from their checking account to creditors.

Develop a Savings Plan

After paying off their high-cost credit card debt and getting their spending under control, Kathi and Curt can work on building their savings for retirement and their daughter's college education. I recommend that they check out the easy-to-use retirement planning software programs available at the Vanguard, Schwab, or Fidelity Web sites. Better yet, they could locate a Certified Financial Planner (CFP) in their area by visiting the CFP Board of Standards at www.cfp-board.org . Either approach will help them figure out how much they need to save for retirement, and whether their retirement goals are attainable while still maintaining an acceptable lifestyle before retirement.

One of the many important insights that can result from that planning effort is figuring out what effect saving for their daughter's education will have on their ability to retire. By examining different retirement scenarios, Kathi and Curt will be able to identify any tradeoffs between, for example, funding college and retiring at 65, and have a conversation about which goals have the highest priority. It may be the case that they will need to make some difficult decisions about which goals to pursue. A CFP can help sort through these issues and help develop a coherent action plan.

One silver lining for Kathi and Curt is that weaning themselves from excessive credit card spending may create the spending habits and discipline needed to save for their daughter's education and their retirement. Fortunately, they have many excellent options for building savings while simultaneously saving taxes:

529 College Savings Plans: These state-sponsored accounts are designed for parents who want to accumulate assets for college education. Under current law, distributions for college-related expenses are tax-free, making them a very powerful wealth building tool, especially for parents with young children. Visit www.savingforcollege.com for a wealth of information about these plans.

Kathi's 401(k) plan: The government subsidizes retirement savings in 401(k) plans by making contributions tax deductible. For example, if Kathi and Curt need to save $1,000 per month in order to reach their retirement objectives, then they can defer this entire amount into Kathi's 401(k) plan. However, because 401(k) contributions reduce their taxes, Kathi's take-home pay will decline by only about $800 per month. Hopefully, Kathi's employer offers a matching contribution that augments Kathi's contribution.

Roth IRAs: Another savings option for Kathi and Curt is a Roth IRA. You don't receive a tax deduction for contributions to a Roth IRA, but the eventual distributions are tax-free, unlike 401(k) plan distributions, which are taxed. Once they contribute enough to get the full matching contribution (if any) from Kathi's employer, I recommend they fund Roth IRAs with Vanguard's "LifeStrategy Moderate Growth Fund," which contains a very broad mix of stocks and bonds in a single fund. They can contribute up to $3,000 each into an account and, to make it easy, establish a monthly transfer from their checking account to the Roth IRA. They can find more information at www.vanguard.com. (If Kathi and Curt max out the Roth IRAs and have room in their budget to save still more, they should then make additional contributions to Kathi's 401(k) plan.)

Curt's retirement plan: Curt is a truck driver and his company doesn't maintain a retirement plan. I suspect that Curt is technically self-employed; if so, then he can also establish a retirement plan (similar to Kathi's 401(k) plan) for himself. A relatively new plan, called a "self-employed 401(k) plan," would allow Curt to save and take a tax deduction for up to $12,000 plus 20 percent of his self-employment earnings. Only Fidelity Investments (www.fidelity.com) and a few other vendors offer these plans right now, but they are quickly becoming more widely available.

Clearly, Kathi and Curt have many options for accumulating savings toward their crucial long-term goals. As important, at just 38 they are still quite young. Many people don't begin retirement planning until reaching their early 40s, so Kathi and Curt definitely have time to recover. However, now that they recognize that their past extravagant spending prevents them from achieving their goals, it is critical that they re-examine their priorities and develop a disciplined and ambitious savings plan.

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Guest columnist Greg Schick, CFP is a financial planner at Kochis Fitz, a wealth management firm in San Francisco.