Reducing Debt & Increasing Savings

Goal

To begin reducing debt and increasing savings.

Baby Steps (Ramsey, pp. 89, 96-97)

Journeying toward financial success is a step-by-step process, just like losing weight and becoming physically healthy. If you woke up this morning and realized you needed to lose 100 pounds, build your cardiovascular system, and tone your muscles, what would you do? If on the first day of your new plan you quit eating, run three miles, and lift all the weight you can lift with every muscle group, you will collapse. Trying to do everything at once can result in feeling overwhelmed and frustrated with your inability to do it all and with the slow progress.

Feeling as though you aren’t accomplishing anything is very dangerous. If you feel that nothing is getting done, you will soon lose energy for the task of money management altogether. Instead, take advantage of the power of focus and the power of priority. The power of focus is that it works. Things happen. You check stuff off your list and achieve actual visible progress. The power of priority refers to the importance of doing the following baby steps in order. [Keep in mind that if you are behind on payments, the first goal will be to become current. If you are far behind, do necessities first, which are basic food, shelter, utilities, clothing, and transportation. Only when you’re current with the necessities can you catch up on other forms of debt like credit cards and student loans.]

1. $1,000 in an emergency fund (Ramsey, pp. 97, 99-100)
   You need a rainy day fund, fast. Money magazine says that 78% of us will have a major negative event in a given 10-year period of time. You get fired or lose your job, you have an unexpected pregnancy, your car breaks down, a loved one passes away, grown kids move home again, etc. Life happens, so be ready by having $1,000 in cash. Keep in mind that this fund is not for buying things or for vacation; it is for emergencies only and needs to be easily accessible. If you make less than $20,000 per year, lower your initial emergency fund goal to $500 instead of $1,000. Do what you need to do to get that money saved, such as working extra hours, selling something, or having a garage sale.
2. Pay off all debts (except your home) with the debt snowball (Ramsey, pp. 104, 106-107, 111, 114)
   This second step is the toughest step because it involves the most effort and sacrifice. But it is worth it. It is easy to become wealthy if you don’t have any payments. Motivation to pay off debt can be enhanced by paying off the smallest debts first. Once the momentum toward becoming debt free is established, it will “snowball”-making it easier to pay off the larger debts. The exceptions to this are if you owe money to the IRS and they will come after you if you don’t pay up or in situations where there will be a foreclosure if you don’t pay off a debt.

   Take a moment to list all of your debts from smallest to largest (excluding your home) using the table below as a guide. After you list the debts smallest to largest, pay the minimum payment to stay current on all the debts except the smallest. Every dollar you can find from anywhere in your budget goes toward the smallest debt until it is paid (see Lesson 3 for budgeting advice). Keep in mind that you don’t typically want to use retirement savings and investments to pay down debts.

   Once the smallest is paid, the payment from that debt, plus any extra “found” money, is added to the next smallest debt. Then, when debt number two is paid off, take the money that you used to pay on number one and number two and you pay it, plus any found money, on number three. When three is paid, you attack four, and so on. Keep paying minimums on all the debts except the smallest until it is paid. Every time you pay one off, the amount you pay on the next one down increases. All the money from old debts and all the money you can find anywhere goes on the smallest until it is gone.

   Debts (listed from smallest to largest by balance)	Total Payoff	Minimum Payment	New Payment (once a debt is paid off, add the next minimum payment to your current amount to calculate your “new payment”)

   Tip: The major elements of making the debt snowball work are using a budget, getting current before you start, smallest-to-largest pay-off, sacrifice, and focused intensity. This means saying to yourself, “To the exclusion of virtually everything else, I’m getting out of debt!” and “I will never borrow again.”

3. 3-6 months of expenses in savings (Ramsey, pp. 124, 129)
   This step is about finishing the emergency fund that you started in step 1. Figure out what it would take for you to live 3-6 months if you lost your income and you’ll know how much money you need to save in order to have a fully funded emergency fund. The purpose of the fund is to absorb risk, so the more risky your situation, the greater the emergency fund you should have (i.e., 6 months of expenses instead of 3). Remember that an emergency fund is for true emergencies and needs to be easily accessible.

   Tip: If you don’t yet own a home, start saving for a down payment or cash purchase of a home after completing step 3.

4. Invest 15% of income into Roth IRAs and pre-tax retirement plans (Ramsey, pp. 139, 141, 144)
   Steps 1-3 take a typical family 24-36 months to complete. Once the debts are paid off and an emergency fund is established, the focus can be turned to building wealth. Perhaps your goal is to not just be out of debt, but to become wealthy enough to give, retire with dignity, leave an inheritance, and have some expensive fun. The goal of step 4 is to allow your money to work harder than you do and focuses on building security through investing in retirement plans. A good rule of thumb is to invest 15% of your before-tax gross income annually toward retirement. The sooner you get started, the more that compounded interest can work in your favor. The benefit of a Roth IRA is that it will grow tax-free.
5. College funding (Ramsey, pp. 152-154, 158-164)
   Saving for your child’s college education is intentionally placed after the aforementioned steps because while a college education is important, it does not ensure a job, success, nor wealth. Only if you mix knowledge with attitude, character, perseverance, vision, diligence, and extreme levels of work will your college degree produce for you. Given this perspective, college can be considered a luxury versus a need.

   Using an Educational Savings Account (ESA), funded in a growth-stock mutual fund, will allow the funds you set aside for your child’s college education to grow tax-free. If you invest $2,000 per year from birth to age 18 through an ESA in mutual funds averaging 12%, you would have $126,000 tax-free. Saving for college ensures that a legacy of debt is not passed down your family tree. Sadly, most people graduating from college right now are deeply in debt before they start their careers. Work study programs, the military, high-paying summer jobs, “underserved areas” programs, and/or scholarships can be pursued as well to help offset college expenses.

6. Pay off your home early (Ramsey, p. 168)
   The final hurdle is to become completely debt-free by paying off your home mortgage. Every dollar in your budget that you can find above living, retirement, and college should be used to make extra payments on your home. On average, it will take you seven years to complete steps 1-6.
7. Build wealth and give! (Ramsey, pp. 181-182, 184, 189-190)
   If you’ve made it to step 7, you likely understand very well what it means to make financial sacrifices and how to work hard. All the sweat and effort is worth it because it has resulted in financial muscle, so to speak. You should do something intentional with that “muscle.” It’s not just to look at; rather, have FUN, INVEST, and GIVE. You’ve earned it. Being in a financially secure position allows you to spend money on things that are important to you without the guilt. Continuing investing will allow you to coast with ease. Giving your money away is possibly the most fun you will ever have with money. If you want to help someone, many times you can’t do it without money. Money gives power to good intentions.

Next Step

Watch the following video to learn more about saving for retirement: