Yesterday, I wrote a post describing our families’ current financial picture and explaining our goals to get out of debt and to start pushing forward towards financial freedom.
One of the main struggles I have with paying off debt is making sure that we are covered financially if I have a bad month at work (I’m self-employed, so my income varies from month to month), or if we have an unexpected expense (as we did this month when our cat got cancer). In other words, how can we afford to put this huge payment on our debt if we have a bad month financially (either lower than normal income or higher than normal expenses) and just have to go into debt to make ends meet at the end of the month anyway?
Can you relate?
The basic strategy that Zina describes in this post is to establish an Emergency Fund BEFORE you start paying off your debts. (She advises a minimum of $1,000, but a better scenario would be 3 months of living expenses). She has six months of living expenses saved because both she and her husband are self-employed.
Once that emergency fund is set up, then you can start plowing money towards your debts. If something comes up, no worry – you have the savings fund to back you up.
That’s the theory anyway – and although I sound skeptical, I completely agree with her advice.
Which is why my Wife and I are going to use it as we begin to push forward with paying down our own personal debts.
- 1 The Cost of Paying Down Debt vs. Investing
- 2 The Strategy That We Will Use to Get Out of Debt
- 3 My Twist on Zina’s Advice – Using A Separate Account to Pay Off Debt Faster
- 4 Why is This Strategy Better Than Paying Debts Directly From Your Checking Account?
The Cost of Paying Down Debt vs. Investing
Clearly, there are pros and cons to paying down debt vs. investing. Ideally, you should take a balanced approach where you pay down as much debt as you can each month while still investing a portion of your income into retirement accounts at the same time. But for most people, this is not a realistic choice. They just don’t have enough income to do both.
There are a number of factors I would consider when deciding which you should do first, which include:
- The interest rates on your debt
- The mental toll and stress that having debt places on your mind
- The current state of the financial markets
- Whether your employer matches your retirement contributions
- The type of debt you have
The Interest You are Being Charged on Your Debt
The higher the interest rate on your debt, the more I would urge you to consider paying off your debt first. On the other hand, if your only debt is a student loan that charges 2% interest per year, you may be more inclined to hold off on paying that debt as long as possible. 2% is as close to free money as you can get.
However, if your only debt is a credit card charging 26%, then you should be striving to pay that off as quickly as possible.
The mental toll and stress that having debt places on your mind
There are some people who just don’t want to have any type of debt. It doesn’t matter if the debt is a student loan, credit card, or just a loan to their parents. They want that debt gone as quickly as possible. For these people, the mental toll and stress that comes with having debt is simply too much to bear. If this describes you, then paying off your debt quickly, regardless of the other factors, is your best bet.
Whether Your Employer Matches Your Retirement Contributions
It’s harder and harder to not contribute to your retirement plan if your employer matches your contributions. This is essentially free money at a 100% return. It’s hard to turn that down.
However, if your employer does not match your contributions, then there is less incentive to contribute to a retirement plan while you have debt hanging over your head.
The Type of Debt You Have
Many people will say that there is only one type of debt – bad debt. But that isn’t necessarily true. There is such a thing as good debt, provided that you manage it properly.
Good debt could be anything from student loan debt to mortgage debt. Also, if you took out a small loan from a family member to start a business, that could also be considered “good debt”.
On the other hand, bad debt is any debt incurred to purchase consumer “wants”. This includes credit card debts, car loans, or other installment loans used to purchase a depreciating asset.
I typically recommend that people get out of their “bad debt” as soon as possible. However, if your only debts are your mortgage or student loans, then you may want to consider investing while at the same time paying those debts off.
The Current State of the Financial Markets
Right now, in July of 2017, the financial markets are ripe for a correction – at least that’s what many of the experts are saying. For that reason, now may be a good time to pay off debt rather than sock away cash in the financial markets.
I’m not one to try to time the markets, but if I were trying to pick a good time to invest, now may not be the best time. For that reason, you may want to consider a debt pay down strategy right now. That way when (not if) there is a financial correction, you may be in a better spot to take advantage of the upswing by investing after all your debts are paid off.
That’s the strategy that I’m going to be using, in any event. So here are my thoughts on getting out of debt.
The Strategy That We Will Use to Get Out of Debt
As you can see from our current financial snapshot, we currently have approximately $66,500 in savings. Given that our monthly expenses are approximately $8,000 after tax, we should have plenty of cash in our emergency fund to start working towards paying off debt.
However, there are a few issues that we must consider as we move forward.
First, some of this cash is earmarked towards my SEP IRA. Failure to put this money into my SEP IRA will cost us approximately $10,000 in taxes for 2016 (as opposed to receiving a refund), so that money is essentially gone.
That means that we will need to replenish those accounts, which leads to the second consideration.
Every month I deposit approximately 5% of my gross revenue from my law office into a “profit account” and an additional 10% into a “tax account”. These accounts are included in our total cash savings. So our cash accounts will continue to grow by $1,500 to $3,000 per month (assuming gross earnings of $10,000 to $20,000 per month, which is typical for my law practice).
I’m religious about these deposits – it is forced savings for my law practice and has given me peace of mind that I can take care of my family when something unexpected comes up.
The last consideration is that we intend to withdraw approximately $7,000 from savings this month to pay off our two highest balance credit cards. That will leave us with only three remaining debts – student loans, our mortgage and a single car loan.
My Twist on Zina’s Advice – Using A Separate Account to Pay Off Debt Faster
One of the great pieces of advice that Zina gives after you have paid off debt is to separate your savings into separate accounts, each with their own purpose.
For example, you might have 4 different savings accounts. One for a future vacation, one for unexpected house repairs, one for a new car, and one for life surprises. If you lump all of those savings goals into one account, it is easy to lose track of what you are trying to do.
This is especially true if the account is at the same bank with your checking account.
By viewing savings as one of your monthly expenses, then you would automatically transfer that money out of your checking account and into the appropriate “bucket” at the bank you use for your savings accounts only.
This is the same idea that I use with my business to save for taxes and set aside profits. I take the money out of my operating account immediately, and then that money gets funneled from my business account to an investment account at Fidelity.
Here’s the twist…
Although this is a great idea to use for your personal savings, it’s also a fantastic idea to use to pay off your debts as well.
Here’s how it would work.
Let’s say that you know that you want to apply $1,000 per month to pay off debt or savings. The first thing you would do is set up a new account that would be used for that purpose.
Next, you would connect all of your debts to that account so that you can easily transfer money from that account to pay off your debts. Even better – you would have your payments come out of that account automatically on a set day each month.
Finally, when you get paid, you would transfer the total budgeted debt payment to that account, pay the minimum on all your debts and apply the extra amount to the account you will be paying off first.
This will basically automate your debt payoff plan.
Why is This Strategy Better Than Paying Debts Directly From Your Checking Account?
The biggest problem with paying debts out of your checking account is something I like to call “self-control”.
Paying your debts out of your normal checking account requires self-control to not overspend the amount that should be used for your “debt snowball”. The debt snowball is the amount you apply to one of your debts, over and above the normal minimum payment.
Once you pay off that debt, your debt snowball theoretically should increase by the amount that you were paying towards the paid off debt. The additional amount would be applied to the second debt until it was paid off, and then the snowball would continue to increase until all of your accounts are paid off.
But when human nature takes over and self-control wanes, it becomes easier and easier to reduce the amount of the snowball and just continue to make the minimum payments on all of your debts.
Do you see where I’m going here?
So by setting up a separate account at a new bank entirely and connecting all of your debts to that account, you can pay off all your debts using the money you have transferred to that account, OUT of your main checking account. This effectively reduces the likelihood that you will spend the amount that should be used for your debt snowball.
Once you have transferred your total budgeted debt payment to the new account (I recommend that you do this automatically), you can use it to pay the minimum amount on all of your debts except for the debt you intend to pay off first. That account will be paid off using the balance of your account.
You could also use this account to do forced savings. Simply add an additional amount to your debt service payment and leave that amount to accumulate in your account from month to month. (And this may be necessary to avoid any minimum balance requirements).
I decided to open up a separate savings account at Capital One as my debt service account. They offer a nice interest rate of 0.75%, and no minimum balance. If you use this link to sign up for a new account, you will receive an extra $25 in your account, and I will receive $20, so win-win.
If not, no biggy, you can use whatever account you like to set up a new account. I will be posting an online review of my favorite bank accounts in a future post.
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