Mellody's Math: Getting Out of Debt

Oct. 21, 2002 -- Kathy and Jim from Texas face the same issues as many other American families — they are overwhelmed by credit-card debt, confused about their savings and spending priorities, and concerned they will never be able to retire or pay for their children's college education.

With three teenage children and retirement looming, their financial situation is desperate. Kathy, 53, and Jim, 59, have a combined income of $130,000 per year but are drowning in debt.

They are eager to reduce their debt, possibly buy a home and send their children to college. The couple must clean up their finances and to prioritize their financial goals.

The segment can be broken down into three main parts: credit cards, home ownership and college.

Credit Cards

The first goal should be to pay off the $70,000 in credit-card debt:

1. Talk the rate down Call your credit-card company and work with it to secure a lower APR (they are currently paying 22 percent on one card).

With a $70,000 balance, paying the minimum, at an APR of 22 percent, it would take more than 70 years to pay off and in that time, you would pay $191,714.15 in interest.

With the same $70,000 balance, and an APR of 18 percent, it would take 48 years to pay off and you would pay $104,615.29 in interest — a financial savings of $87,099 and a time savings of 22 years.

2. Cut 'em up and cancel!

Take out a scissors and cut up your five credit cards. In addition, absolutely resist any store offers to enroll in a credit card or charge card for instant savings. For example, they recently purchased a new computer at CompUSA with a CompUSA credit card.

You can not negotiate with a credit-card company after you cancel the account, so make sure you speak to them about the possibility of lowering your APR BEFORE you cut up your plastic.

3. Pay more than the minimumIf the Kathy and Jim choose to pay off their $70,000 credit-card debt by paying only the traditional minimum, it would take them almost 48 years in which they would pay $105,000 in interest alone (assuming an APR of 18 percent). However, if the couple could pay $2,500 a month toward their credit-card debt, it would take them only three years and they would save more than $83,000 in interest.

The extra savings opportunities do exist for the Jim and Kathy. For example, if the entire family starts making their lunch at home, instead of buying it, and cancels their premium cable service, it would add up to a savings of more than $250 a month.

Should They Buy a Home?

Before the family moved to Texas, they were homeowners. According to Kathy, they really want to buy another home. But first, the true cost of home ownership:

According to Kathy, it would cost her family around $350,000 to purchase a suitable home in their suburb of Dallas. If the couple were to put 5 percent down, $17,500, they would face monthly mortgage payments of more than $2,800 (assuming a 30-year fixed rate of 6.5 percent), which includes the cost of insurance and property taxes. After deducting their monthly interest payments and property taxes, the couple would face an actual cost of $1,900 a month.

While Jim and Kathy would benefit from the tax savings of home ownership, before even considering such a purchase, they must reduce their credit-card debt and save enough money for a down payment.

That said, in three years, the couple will be empty-nesters. Suddenly, their home purchase for a family of five is now more house than the couple possibly needs.

Yes, after the credit cards are paid off and Jim and Kathy are able to put enough money away to cover the down payment, they could buy a home.

College?

Kathy says saving for college is a bigger priority than saving for her and her husband's retirement. However, retirement should definitely come first.

With their current debt situation, saving for college is not an option. Instead, Jim needs to consider contributing more to his 401(k) — the catch-up provision now allows him to make a contribution of up to $11,500 a year.

The children should hit the books and make an exhaustive scholarship search, because there are many wonderful financial opportunities for college students and no scholarships for retirees. In addition, Kathy and Jim's children will be able to pay off their debt much faster than they could.

Mellody Hobson, president of Ariel Capital Management in Chicago, is GoodMorning America's personal finance expert. Click here to visit her Web site, ArielMutual Funds.com. Ariel associate Matthew Yale contributedto this report.