Category: Debt Free Living

If you’ve already got a house and you’re not planning on getting another mortgage ever again, skip this week. Otherwise, onward!

While this is geared more towards young couples who are renting, there are some valuable things in here for people who may be moving up–or down–in house. Once you’ve paid off all your debts and built up your emergency fund, you can start saving for a house!

Now if you’re anything like my wife, all the blood just drained out of your face. “You want me to wait a billion years and pay cash for a house?” Well, yes, but I realize most people aren’t willing to rent for 5-7 years longer in order to not get a mortgage. In fact, most people don’t want to rent for an extra two years and buy a small-ish home–they want to go straight for the three bed, two bath, two car garage in the nice suburban neighborhood near where they grew up.

Well, to do that is going to take a lot more money than you’re going to have so the first rule is lower your expectations. You’re not going to get the fancy house…yet. Later, when you’re a bajillionaire, you can have the nicest house in town–but by then you probably won’t want it.

So if you’re not going to pay cash, and you’re not going to go $300,000 in debt to get what you want, then what do you do?

You put 20% down and get a 15 year mortgage that has a payment of about 25% of your take home pay. The 20% down portion gets rid of PMI, which will cost you about $50/month for every $100,000 you borrow. If you are going with manual underwriting because you’ve never had a credit score, or your credit score has fallen because you stopped borrowing money, the large down payment will also get you a better interest rate since the bank will have instant equity if they have to foreclose on you. Less risk == lower rate.

Capping your payment at 25% of your take home pay prevents you from becoming house poor and protects you from foreclosure and other financial difficulty. Our house payment ended up being about 12% of our take home pay based on some things I’ll cover in a later post.

Getting a 15 year mortgage does three things: First, it lets you get a much lower rate because the bank is risking it’s money for half the time. It’s less exposed to risk, so your rate is lower. The second thing it does is it makes you build equity faster because you’re paying more towards the principal every year. Lastly, it saves you a boatload of money over the long run. Let’s look at an example:

Let’s say you bought a house with a closing price of $187,500. You put 20% down, so you need to borrow $150,000. At the time of this writing, interest rates on a 30-year fixed rate mortgage are around 3.75%, and for a 15 year they are 3.125%

With the 30 year, your payments will be $695/month and you’ll pay $100,000 in interest.

With the 15 year, your payments will be $1045/month, but you’ll only pay $38,000 in interest.

You save $62,000! That’s a lot of ammo!

Now, I hear you over there in the back saying “Yeah, but it costs $350 a month more!” Phooey! That’s like saying your IRA costs you $416 a month!

It’s forced savings. You get the extra $350 a month back when you sell the house! Wednesday I’ll go a little bit further into the math around financing, but for now just know this: The longer you have a mortgage, the more your house costs you.

Tomorrow, I’ll go over the process we went through when buying our first home.

Note before we begin: By the time you get here, you’ve probably got a pretty good idea for what works and what doesn’t in your household. This post is to provide guidance, not gospel.

“When you are prepared for the zombie apocalypse, a hurricane is just a storm.”

We’ve all heard that one, and it’s true. We like talking about the zombie apocalypse because it’s a very good way to talk about serious subjects without the buzzkill of reality. Hurricane prep isn’t fun, or sexy, anywhere near the front of your mind. You know you need to do it, but come hurricane time you’re in line buying plywood like everyone else who didn’t prepare. But Zombies? Now you’re talking!

Baby Step 3 is the financial equivalent of preparing for zombies. If you are ready to have zero income from any source for 6 months, the AC in your house going out is a just minor inconvenience.

After paying off everything except the first mortgage, Dave Ramsey’s recommendation is to stockpile 3-6 months of expenses. Since you’ve just finished your debt snowball, just consider this your last debt. Take that gigantic payment you were making on your student loan and start sending it to your money market account and you’ll be there in no time.

So, three to six months of expenses, eh? Well, do I do 3? Or should I go the full 6? What if I want more than that?

That’s up to you and your spouse. If you’re young and single, 3 months is probably okay. If you’re married with 2 kids and you’re the only one that works, 6 months may not be enough in the Obama economy. You probably don’t want more than 18 months worth of expenses sitting in an account getting (as of today) 0.9% interest, because really if you have to live on savings for more than a year you’re going to be looking at liquidating other assets anyway.

Note that this is 3-6 months of expenses, not 3-6 months of income. Expenses would be defined as those reoccurring items that you need to survive, but you can extend that to keeping your standard of living. Contributions to savings, extra house payments, retirement, etc, would not be included in expenses. Cable, rent, utilities, and blow money would be. This is whatever you decide, but in my house it comes to be a little more than half of our take home pay (we’ve continued to keep a modest standard of living despite getting significant raises).

If you’re married, the spouse that wants more money in this account wins! Let’s say you do the math and your monthly expenses are $2,000. Six months of expenses would be $12,000. You think you could get by with $10,000 but your wife says she needs $20,000 in the bank to feel safe. She wins! Now, if she said $100,000 then you’d have a case for her being unreasonable, so unless it’s something like that then just let it go.

One thing to remember, though, is that Baby Step 3 MUST BE COMPLETE before moving to Step 4: Saving For Retirement! If you don’t have a house yet, you have to have your emergency fund fully funded before you can start saving for your down payment (Baby Step 3b)! Take these things into consideration when discussing how large your emergency fund should be. Your husband will probably settle for a smaller emergency fund if he realizes he’ll get a garage sooner by doing that.

Having twenty thousand dollars(!) sitting in a bank earning monthly interest after having recently owed over forty thousand dollars plus monthly interest is an awesome feeling to have. I have things that keep me up at night, but money isn’t one of them. Like I said at the beginning, it turns what would be a major freakout level problem into a minor inconvenience.

It turns a hurricane into just another storm.

One common excuse reason people give for keeping a credit card is that they pay it off every month, so it’s okay for them to keep it.

I have never understood this logic. If you have the money to make all the purchases, why not just use the money instead of the credit?

I covered this about two years ago and got some interesting responses, which I’d like to address again here.

Reason #1: Credit cards are safer than debit cards
This used to be true many years ago. MANY years ago. It hasn’t been true for more than a decade now, but people still believe this myth. Today, Visa and MasterCard provide the exact same protections to debit cards as they do to credit cards. EXACTLY the same. People go through some serious mental gymnastics to try to counter this simple fact, but it says it right there on their websites. It’s a lot like telling people that the Earth isn’t flat or that fire really can melt steel–no matter what evidence you show them, some people will simply refuse to believe it. Don’t be that guy, please!

(One note, though: If the crook gets your PIN and card number, there are no protections. That’s also true of credit cards that allow cash advances, though. My advice is to always run your debit card as a credit card in case you run into a situation where the vendor is compromised and an attacker is collecting card numbers and PINs. Small chance, but it happens.)

The difference, of course, is that when someone steals your debit card and uses it as a credit card, the money comes directly out of your account. About ten years ago someone stole my debit card and within 24 hours I got ALL my money back. If that happened to me today and I needed to make a purchase during that 24 hour period, I’d use the emergency fund. You would already have that before cancelling all your cards, remember?

Reason #2: I get points/rewards/cash back for using a credit card
Same goes for debit cards. Your bank may not offer rewards on debit cards, but if it’s important enough for you then all you have to do is switch banks.

Reason #3: It keeps my credit score up
So what? The only reason to have a credit score is to borrow money. Please understand there is a distinction between having bad credit and having no credit. As you pay things off and close accounts, your credit score will likely fall, but anyone who runs a credit check on you will see that it isn’t because you’re not paying your bills. Now, someone may try to bring up that with a low credit score you may have to pay a deposit on utilities, but that’s only true for a very narrow subset of the population. Basically for this scenario to be possible you would have meet all the following criteria:

1. Enough of a credit history to have attained an acceptable score at one time.
2. Closed enough accounts to make your score no longer acceptable.
3. Not already doing business with the utility company, or had an account with them in the last year.
4. Not transferring service from somewhere else

For example, when I moved from one county to another, all I had to do to avoid putting down a deposit on my electricity was call my old electric utility and have them send the new company a letter of credit. Basically, they told the new company “This guy has been paying us on time for xx months with no delinquencies.” No deposit needed. I moved back to the first county 360 days later and didn’t need a deposit or a credit letter since I’d had an account there recently.

Now, if I had been living with a roommate for a few years and all utilities were in his name, including the lease, I would have had to put up a deposit. I seem to recall having to do this for my first apartment after college, and I had a great credit score!

Other than that, there isn’t a real, concrete reason to worry about what your credit score is doing. It just doesn’t affect your daily life.

Reason #4: I act responsibly with my card
Then you will also act responsibly with your debit card and cash.

Okay, so those are some of the excuses reasons why people keep their credit cards. Now for some of the reasons you should be terrified of them:

Reason #1: You spend more, generally
Research shows that when you use credit cards, you will spend more than you would with cash. Who cares that you get 2% cash back when you spend 40% more?

Reason #2: You’ll be tempted to use the card rather than the emergency fund
Remember how I said in the Starter Emergency Fund post that the emergency fund needs to be inconvenient? The point of it being hard to use is so that you don’t “accidentally” use it for something that’s not an emergency. Well, if you’ve got this hard to use cash reserve, and this easy to use credit card, which one are you more likely to use?

Reason #3: It’s a whole lot easier to get in trouble
I don’t have credit cards, so it’s impossible for me to “accidentally” accrue credit card debt. It’s also impossible for me to rationalize spending more than I should in an emergency situation. Case in point: Recently a friend of mine had her car totaled. A drunk driver slammed into her parked car, and then ran off never to be seen again. She and her husband are a one car family, and had purchased the car a few months earlier from a family member for $1200. It was a great deal, and the car was fully insured. The check they got from insurance was for $5,000! Not a bad deal!

This friend is of the “I’m a responsible person, so it’s okay for me to have a credit card” mindset. She asked for my help looking for cars, and at one point found a car she loved for $6,000. When I asked her if she had the extra $1,000 for the purchase price and the money to cover taxes, tag, and title fees, she told me that her plan was to just get a cash advance on her credit card. This is a person who spent a couple of years fighting to get out of credit card debt, yet this thought crossed her mind. I doubt she would’ve considered this course if she didn’t already have the card–she just would have avoided cars slightly outside of her price range. She didn’t end up getting that particular car, but I don’t know if she did end up using a cash advance at a 20% + prime rate to finance the car she did buy.

Reason #4: The Credit Card companies hate you and will think of new and interesting ways to totally screw you.
Do you know what a deadbeat is? You may think it means someone who doesn’t pay, but if you are in the credit card industry it means someone who doesn’t pay interest, ie the “but I pay mine off every month!” customers. After the CARD act was passed, banks started talking about these deadbeat customers and how they will no longer get a “free ride.” The first wave of this is the return of the annual fee. There are also countless consumer complaints and stories about credit card companies and banks either holding payment until after the due date (so you default, get a fee, and they charge you 30% interest that month) or rejecting payment altogether. They do this because most people will only fight about it for a very short amount of time before accepting defeat and paying up.

So, there you have it. I suspect I’ll get a lot of haterade for this one, because people are pretty set in their dogma about credit. Let ‘er rip!

[ETA: I originally wrote this post before Bank of America announced they would start charging $60 a year for debit cards. The easy solution there is to switch to another bank. I mean really, after all the shit they’ve pulled why were you still there anyway?]

One common point of resistance to getting rid of credit cards is the old “I need one to travel for my job.”

Well, that’s a load of crap. It can be done, and I have been doing it for years.

The best way to go about this is to have a company card that you are not liable for, and that you don’t pay the charges on. The bill goes directly to your company’s accounting department and they pay it after you send them your expense report. Yes, these type of cards exist. No, you’re probably not going to get a say in whether or not your company chooses this type of card.

For two years I had a card like this. Every other week I flew from Nashville to St. Louis, rented a car, and got a hotel room. I paid for everything with my company card and never once saw a bill or wrote a check. It was all very nice. I’m sure that if I ever did something stupid like buy an HDTV using that card I would at a minimum get a stern talking to, possibly all the way up to criminal charges (buying a TV for yourself with company money would be embezzlement or fraud, I’m sure).

But then! TRAGEDY! My company was bought by a very large mega corporation that you’ve probably never heard of. They had a policy of reimbursing employee expenses. Basically, employees became this multi-billion dollar company’s payday lender (without the interest). I was expected to make the charges, file my expense report, and then wait for them to reimburse me. Most people would just go get an AmEx card and hope the reimbursement check came before the bill came due. In fact, the new company had a “preferred” card for you to use (so not only were they making interest by not paying expenses directly, they were also making money in referral fees to the credit card company).

The last time I used a credit card was in 2004. I will never do it again. So, what to do?

I had two years’ worth of data telling me how much I spent for a week in St. Louis. The maximum amount of weekly charges in that period was somewhere in the $1200 range, with a touch over $1000 being the average. Luckily, these policy changes weren’t going to take affect for a couple of months so I had some time to make accommodations.

I opened up a checking account at ING Direct, and also added a money market savings account. ING gives you a MasterCard debit card for the checking account (which pays a tiny bit of interest) and allows you to instantaneously transfer money from your savings account (which pays quite a bit more interest) into your checking account. Since I was traveling every other week, I put two weeks’ worth of expenses into the savings account, plus a little extra. I could go up to five weeks waiting for reimbursement and still be okay.

Now, my coworkers all went and got the credit cards. We were told that reimbursements would be “nearly instantaneous.” That’s an exact quote. What does nearly instantaneous mean? Apparently 3-4 weeks.

So four weeks after our first trips on the new policy, my coworkers were complaining about not being reimbursed. I remember distinctly one proclaiming that he wasn’t going to pay the bill he’d just gotten in the mail.

You know, the bill for this new personal card that doesn’t affect anyone but himself.

Yeah, that’ll teach your employer!

So what were my coworkers’ choices? One possibility would have been to make a minimum payment and start accruing interest on the balance while waiting for reimbursement.

The other choice was to take money out of savings and pay the bill. That, of course, assumes they had several thousand dollars available and that they were willing to part with it not knowing when they would get paid. This choice sounds remarkably like what I did, only in reverse. I chose to part with my money first and forego the possibility of paying interest or making a late payment.

I realize that it may be difficult to suddenly switch from using a credit card to using a debit card. If you decide to go this route, just set a goal date of, say, three months from now to make the switch. Use that time to set up the new account, start putting money in it (I would actually put this at the top of your debt snowball), and switch your reimbursement account with your payroll department to this account.

It might sound scary to go this route, but if you know what your average expenses are and your reimbursement timeline, there is absolutely nothing to fear.

Last week I covered the Debt Snowball and mentioned that you needed to have a budget, so this week I’ll cover how to do that.

Bah! Why are you covering this? I know how to do a budget!

Really? Off the top of your head, what’s your monthly budget for clothing? Groceries? What’s your budget for gas? Not, “Oh, I usually spend about…”–that’s not a budget.

A budget is where you declare “I have $300 to spend on gas this month, and I will not spend any more than that.”

What we do, and what Dave Ramsey teaches, is called a zero based budget. Basically what that means is we know where every single dollar we make is going to go before we get paid. So you “spend” your entire paycheck the day you get it. Using this method, if you go over budget in one category, you have to take that money from another category because by now you’ve stopped using credit cards.

So if you had $300 budgeted for gas, but with 5 days left in the month you have 1/8 of a tank, you’ve got to take money from somewhere else. Perhaps clothing or “blow money.” And next month, plan better :D.

Here are the basic categories I used when I was single and doing this plan all by myself:

• Groceries
• Fuel
• Bills
• Rent
• Utilities
• Insurance
• Cell Phone
• Blow money
• Debt Reduction
• Visa
• Mastercard
• Car Payment
• Student Loans

That’s a pretty simple list. It is a good starting point, but if you want something a little more detailed, check out this budget form from Dave Ramsey.

A note about Blow Money: This is your walking around money. This is where you pay for renting movies, going out to dinner, and hitting the range. I discovered that I could get by with $60 a week in blow money and that has been my amount for several years. My wife gets the same amount even though she doesn’t make as much as I do. (That suppressor I bought recently was bought with blow money I had been saving since January)

A major component to the budget is the envelope system. What that means is that for certain categories you take cash out of the bank and put it in envelopes. When I started, I used cash for groceries, fuel, and blow money. Pretty quickly I learned that paying cash for fuel totally sucks so I stopped doing that. Now I use a debit card at the pump.

I did kind of a weird thing with regards to bills. I opened a second checking account and paid all my bills using that account. I signed up for auto-payment wherever possible and used online bill pay. The only check I had to write was to my landlady. I knew how much my monthly bills were going to be so I divided that by two and deposited that amount into the bills account every payday. It worked out really well for me and we still use that system today.

So this is how it looks on payday. Let’s say you get paid twice a month, and your paycheck is $1670 (speaking of which, you have stopped your retirement contributions, right? That’s not until step 4). Here is what it looks like:

• Go to the ATM. Take out $100 in cash for groceries and $120 in cash for blow money.
• Transfer $800 to the bills account
• Apply $500 to The Debt Snowball

You now have $120 in your pocket and $150 in your primary checking account for fuel. In an envelope you have $100 to buy the next two weeks’ worth of groceries. The rest of your paycheck has been spent.

Now, I don’t know what your situation looks like, but this is the basic idea. To get your numbers, go through your bank and credit card statements for the last six months and see where you spend your money. You might be surprised, as I was, at where all your money has gone!

When I did this, I discovered that while I thought I was spending $80 a week on groceries, I was actually spending almost $300 a week–because while at the grocery store (which was Wal-Mart because that’s your choice when you live in Mississippi) I was picking up things like DVDs and the occasional digital camera. The other thing that really surprised me was how much less I spent if I used cash. There’s something psychological about it.

Last week I covered Baby Step 1: The $1000 Emergency Fund. That step can usually be completed in a month or so, depending on your situation. From there, you move on to what really is the core of “the plan”–The Debt Snowball.

In the debt snowball, you take all of your debts and list them smallest balance to largest balance. ALL OF THEM. This includes the twenty bucks you borrowed from your fishing buddy. It includes the $75 you owe your dentist for the cleaning two months ago. It includes your cars, motorcycles, and boats. Store cards, credit cards, and loans from parents. Everything.

Interest rates only matter as a tiebreaker. The reason you do it this way is entirely psychological: reducing the number of creditors is a better positive reinforcement than reducing your total debt. If you pay off $1000 of debt and get rid of two store cards you feel like you’ve made a whole lot more progress than if you pay off $1000 on an account and you still owe $7500. Going from 7 creditors to 5 within the first month is an awesome feeling.

Okay, so how does this work? Well, you take your ordered list of debts and you pay minimum payments on all of them. Except the smallest one. That little bugger? You’re trying to murder him. Kill him with fire! Any extra money you have in the budget (you do have a budget, don’t you?) goes to kill him. Every bit of overtime goes on that guy. If you sold an extra rifle you put that money on the smallest debt (Later, you can buy a new one. I hear they keep making them).

When that guy is dead, you move up the chain. Only this one will go a bit faster, because you don’t have that first debt’s monthly payment anymore. So if you had a Visa with a $25 minimum payment as your first debt, and a Discover with a $45 minimum, your new absolute lowest payment you’ll make on the discover is $70. Make sense?

By the time you get to the last debt, you could very well be paying thousands of dollars every month on it without having changed your lifestyle very much since the beginning. When I was single, I paid about $1600/month on my student loans at the end, which was about half my take home pay. I think the number was close to $3500 at the end of my wife’s snowball.

This step will take 18-24 months on average. I did it in 30 months when I was single and we paid off my wife’s debts 28 months after we got married (our debts were roughly equivalent and for the same things).

When interest rates for my money market account (AKA The Emergency Fund) were north of 6%. The bank just notified me that rates are down to 0.87% now, which is still better than the rate for regular savings accounts (0.25%)

Last week I gave a quick overview of the Baby Steps. Before you start, you have to be current with everyone. Since I didn’t have that particular problem (I got really, really close, though) I can’t give you any advice there.

I can talk about the subsequent steps.

Baby Step 1 is your starter emergency fund of $1000. Do this as quickly as you can, because it’s the thing that keeps you from going backwards in “the plan.” The idea is to put this money into a money-market account with check writing privileges and no minimum balance. Bankrate.com has a good tool for finding them. I keep three checks for this account behind the checks for my regular checking account.

I would avoid accounts that only allow debit card purchases. This account should be inconvenient to use and a debit card is really convenient. You don’t want to “accidentally” spend your emergency fund on something that’s not an emergency. I started off with a savings account at the same bank I had my checking account with and I bought an XBOX off eBay using my emergency fund about two months into the plan. I simply jumped online, transferred the funds, and hit “Buy it now!”

Don’t do that. I shouldn’t have and almost immediately I felt guilty about it. The next day I opened a money-market account with a bank in Utah (I still have the XBOX and use it daily, FWIW). I can get my money out one of two ways: Electronic transfer that takes 3-5 business days or writing a check. Another thing that will help keep you from accidentally spending this money is that you are only allowed to make 3 withdrawals per month from this type of account.

Now, a lot of people think that $1000 is just not enough for an emergency fund. I found that in the 2.5 years I had that little tiny account, I was able to cover every emergency I had with that fund. The only exception was when I bought a $1500 vehicle after my previous one left parts of the transmission on the highway. In that case, I had to wait until my next payday to get the extra $500 and I bummed rides to work from co-workers/roommates until then. I could have gotten by with an $800 car (and later I did just that, but that’s another story).

The entire purpose of the emergency fund is so that you can cancel all of your credit cards. ALL OF THEM. Once I got my emergency fund in place, I never used another credit card again. Ever.

If you think you need to keep a Visa with a $2000 limit on it “for emergencies,” then simply put $2000 in your emergency fund instead. If you’re married and have kids, your spouse might insist on even more. It’s probably unnecessary to keep more than $2000-$3000 in this emergency fund, with two notable exceptions:

1. You reasonably expect a coming disaster, such as a job loss or medically necessary surgery.
2. You are about to have a child. (Not expecting to get pregnant, mind you, but actually pregnant or approved for an adoption you started before all of this. Knowing a due date is a good indicator for whether this applies to you.)

In both of these cases you put everything you can into your emergency fund. This is true for all stages of the plan. We are on Baby Step 4, but we are piling up cash for when lilwizard shows up at the end of February. When these things no longer become an issue (your job stabilized, you’re back to work after the surgery, or mom and baby are home from the hospital with no complications), you continue with the plan.

Again, I know $1000 does not sound like enough to some people. Even $4000 might not sound like enough. Trust me, it is.

The coolest thing in the world will happen to you the first time you use your emergency fund. You feel empowered. The first time I used my emergency fund was when my radiator blew up during a radiator flush. Two hours later, I wrote a check for $300. I literally cried because I realized I had the money to cover this unexpected expense. It was awesome.

So, you want to be completely debt free? The steps are simple. The execution is difficult because it involves telling yourself “no” a whole lot. You can do it, I promise.

I am a huge Dave Ramsey guy. I followed his program and it’s done wonders for me and my family. Here’s something a lot of people don’t know or understand about his program:

You don’t have to buy anything.

Seriously.

The first two years I was doing “the plan” Dave got exactly $0 from me. All I did was listen to the radio show, which you can do over the internet for free if there isn’t a local affiliate. I didn’t go through Financial Peace University until I had already completed Baby Step 2.

Wait, what?

There are seven (really, there are nine) Baby Steps that walk you through to retirement. Step 0 is to be current on everything.

1. Save $1000 as a starter emergency fund.
2. Pay off your debts, smallest to largest. Pay minimum payments on everything except the smallest, and absolutely freaking kill the small one.
3. a) Put 3-6 months of expenses away into a Money Market. This is your fully funded emergency fund.
   b) Save for a 20% down payment on a house, plus all closing costs and moving expenses, including all that furniture you want to buy.
4. Invest 15% of your gross pay into retirement accounts.
5. Save for your children’s education.
6. Pay off the house.
7. Put your former house payment into mutual funds.

Steps 0 through 3b are done in order, to the exclusion of all other steps. Yes, this means stopping the 401K while paying off Visa.

Steps 4, 5, and 6 are done concurrently. Step 7 is obviously started when the house is paid off.

That’s it. That’s the entire plan. No “buy this software!” or “attend this seminar!” required. I will tell you that there is value in going to FPU, and it’s well worth the money, but if you’d rather take the $199 (or $99 when you catch it on sale) and put that on your Capital One card, by all means do that. That’s pretty much what I did.