Are you in debt?  If so, you are in company with millions of Americans.  However, 2012 can be the year that you resolve to be debt free or to significantly reduce your debt.

My preferred method of paying down debt is two pronged—use the debt snowball (pay down smallest to largest debts, regardless of interest rate, and apply as much as you can to the lowest debt while paying minimums on all of the other debts) and snowflake money (find extra money throughout the month to apply to your debt immediately, as you earn it).

Since late October, my husband and I have been using this two pronged strategy to pay down nearly $5,000 of our debt.  We were able to make progress so quickly by snowflaking.  Here are a few ways we have been able to successfully snowflake:

1.  Sell your “stuff”.  Look around your house.  What do you have that you haven’t used for awhile?  Do you have a treadmill that you hang your clothes on and haven’t actually used in three years?  Sell it.  Old textbooks lying around from last semester?  Sell them.  Outgrown baby clothes?  Yep, you guessed it, sell them.  In a six week spurt, we sold most of our kids’ outgrown baby clothes and gadgets like high chairs and bouncy seats on Craigslist and eBay.  We also sold a dishwasher we no longer needed.  In the six weeks, we made a little over $700.
2. Use your “found” money.  Until you pay attention, you may not realize how much found money you have every month.  (Found money is money you get that you weren’t expecting or money that you thought you would have to pay out but didn’t.)  My son attends a private afterschool program two days a week, and in both November and December, we had to pay $110 less than we normally pay monthly because of vacations and holidays.  That was money we would have paid anyway, so it was easy to snowflake.  Other sources of found money could be rebates, money you save by using coupons, change you save during the month, insurance reimbursements, flexible spending reimbursements, and monthly bills that are cheaper than you expect, to name a few.
3. Get extra work.  Perhaps you can find an extra job in addition to your full-time job.  If you make an extra $200 a month at your second job, snowflake all of that money on your debt to see it disappear faster than you thought possible.  I took on one extra job specifically to snowflake.  I can decide to work one to four hours a week with this job, so I am motivated to work as much as I can because all of the money will go to my snowflake.

If you are trying to pay down debt, don’t dismiss the idea of selling stuff around the house.  Once you look around, you may find many things that would better serve to be sold and pay down your debt rather than sitting in your closet gathering dust.  Likewise, many of us have the unfortunate habit of simply absorbing any extra money we make or “find” into our regular budget.

Instead, snowflake it immediately on your debt.  Using these strategies, we have been able to make a significant dent in our debt and shave off the number of months it will take to become debt free.  I am confident you could have the same success.

*Photo by LaoWai Kevin*

Those dedicated to strengthening their financial situation often find themselves facing the decision of paying off debt or building a large emergency fund.  There are benefits to both, and the final decision will ultimately be based on your personal preference, risk tolerance, and priorities.

Benefits of Paying off Debt First

- You free up income
- The burden of debt is lifted
- Usually leads to higher credit score which can lead to lower insurance premiums
- The math supports paying off debt first as the interest of most debt is higher than the APY of savings accounts

Build Savings First

- Security against unforeseen circumstances
- Buffer in case income source is reduced or terminated
- Peace of mind

No matter what you decide, at the very least a minimal cash reserve should be set aside.  Should you grow this to 6-8 months of expenses while paying the minimum on debt?  Or should you throw everything you can at debt while slowing down, if not stopping your emergency savings funding?  Once you begin to annihilate debt it can become very tempting to throw every penny towards debt reduction, however you’ll want to make sure you are not putting yourself in a position to use credit as a crutch should your income cease or decrease.

Take this short quiz to help you decide if you should build up savings or pay off debt.  This is not a scientific quiz, for entertainment purposes only.  As always, you should consult a financial professional before making any major decisions.

1. Describe your househould income:  a. Single Income (1)    b. Dual Income (2)
2.  Describe your job:  a.  Irregular salary (1)     b.  Regular salary (2)
3.  Do you have dependents?  a. Yes (0)    b.  No (1)
4.  Do you have multiple steams of income?  a.  Yes (2)    b.  No (1)
5.  If you lose your job or primary source of income, how long would it take you to replace it?  a. 0-3 months (2)    b   4-6 months (1)     c.  6-12 months (0)

Add up the points corresponding with your answer.  If you scored:

Between 3-5 points:  You may want to err on the side of caution and build a larger emergency fund.  Your financial situation is somewhat volatile and an unforseen disturbance may make it difficult to rebound.

6 points:  You’re in the middle of the road and could sway either way.  You have enough liberty to focus on debt payoff, however stashing a little more in savings wouldn’t hurt either.

Between 7-9 points: You have enough freedom to attack debt.  Your diverse income gives you enough flexibility to adapt and adjust as necessary.

My Strategy:

I’ve used a modified Total Money Makeover approach.  Dave Ramsey suggests saving $1,000 minimum, then attacking debt.  My risk tolerance is not high enough for that, so I opted for a larger emergency fund before I shifted my focus to OPERATION DESTROY DEBT.  I still fund the emergeny savings, but not with as much intensity until debt is eliminated.

What about you?  What’s your strategy?  What’s your outcome according to the quiz?  What other questions / factors would you add?

I am NOT a fan of debt, so why in the world wouldn’t I pay off my student loan with “gazelle like” intensity?

The screenshot below will explain why I considered a less than aggressive payment strategy for my student loans.  Think back to 2002-2003, college consolidation loans hit an all time low interest rate.  Everyone was talking about consolidating!  I couldn’t surf the Internet or watch TV without hearing about consolidation before the new rates applied.  I consolidated and got locked into a 3.75% fixed interest rate.  I don’t remember what it was before, but if I had to guess it would be around 6-8%.

Typically, I would recommend paying off debt before investing.  For example,  someone with credit card debt at 8% APR may be tempted to invest and hope for a 10-12% return.  The problem is, you have a guaranteed debt vs. a probable return….it is apples and oranges.  But what if you could guarantee the interest earned could be greater than the interest paid?

My original plan was not to include my student loan in my debt snowball because I was sure I could find an investment vehicle that would guarantee higher than 3.75.  I got an ING Direct account in the good ol’ days when the APY ranged from 4-5%  and 5% CDs were available at every bank.    Well, in preparing this article I search for CDs, Money Market Accounts, and High Yield Savings Accounts that offered a 4-5% rate of return…and here is what I found out…they don’t exist!  At least not in 2010.  It’s a different world than it was 7 years ago.  Here are the highest rates from bankrate.com at the time of this article:

• 5 yr CD: 3.49%
• 5 yr Jumbo CD: 3.20% (If I had $100,000 for a jumbo CD, my student loan would be paid off!)
• Savings Account: 1.50%
• Money Market Account ($10,000 balance to open): 1.50%

I even looked at government bonds (which are not guaranteed, but very low risk) and the rate of return is not above my loan interest rate of 3.75%

When I first started writing this article it was titled: Why I’m NOT in a Hurry to Pay Off My College Loans but when I took a close look at the numbers my game plan started to change.

My theory was that I could find some sort of savings account with a rate of return higher than my loan interest rate.  I would save the money and at the end of the year I would apply a percentage of the interest towards my student loan and reinvest the rest.  This plan was erroneous for the following reasons:

1. I was comparing fixed rate interest vs. variable rate interest: My loan interest rate is 3.75%.  Period.  However, the interest rates of CDs and Savings accounts vary over time.  So even if I was able to find a 5 year CD at 5% interest (virtually impossible), there is no guarantee that I would be able to find the same interest rate again after the initial CD matures.

2.  When an inflation is calculated, the difference in savings practically diminish.  The graph below is from US Inflation Calculator however, I have plotted the average inflation rate over time (2000-2009) to be 2.87%.  So a CD with an APY of 5% is only generating 2.13% return when inflation is factored in.  Considering the average rate of inflation, I would need a return of 6.62% just to break even.  I think it is safe to say nothing guarantees that high yield.

The bottom line – it is still  DEBT!  The Bible says the borrower is slave to the lender, and we are admonished to pay back what we borrow.  Do I really want to be bothered with this monthly payment for the next 10-15 years?  I don’t think so!

Also, there is risk involved in prolonging repayment.  God forbid, but in the case of financial hardships that debt still has to be paid when it could have been paid off years ago.  The unique thing about student loans is it’s pretty easy to get financial hardship deferments (almost too easy), however…while your loan is deferred that interest is still accumulating adding to your mountain of debt.  Furthermore, student loans are not dissolved in bankruptcy (no, I am not advocating bankruptcy but I do realize for some it is a reality).

So, will I be adding my student loans to my debt snowball?  I’m leaning towards yes!  However, I also want to increase my retirement savings as I am nowhere near maxing that out.  Gazelle like intensity on the student loan debt?  Maybe a jack rabbit!

Are you paying off your student loans as quickly as possible or investing at the same time?

“Health is not valued till sickness comes.”

Please answer honestly, this will be for you to retain. Many of the questions are subjective, they are designed to get you to think about the impact of financial decisions and debt.  On a sheet of paper, number 1 through 12, for each question write yes or no.

1. Are your debts adding negative pressure to your home life?

2. Is your FICO credit score less than 620? (Also answer “yes” if you do not know your score)

3. In the past year, have you been charged an insufficient funds or overdraft charge from your bank more than 3 times?

4. In the past year, have you used a payday or title loan?

5. Have you ever made unrealistic promises to your creditors or given them false contact information so they could not bother you?

6. Does the pressure of your debts make you careless of the welfare of your family?

7. Do you ever fear how you would financially support yourself and family if you lost your job?

8. Do you typically pay the minimum required on debts?

9. Have you ever borrowed money without giving adequate consideration to the rate of interest you are required to pay?

10. Do you usually expect a negative response when you are subject to a credit investigation?

11. Have you ever developed a strict regimen for paying off your debts, only to break it under pressure?

12. Do you often find yourself unable to account for the money that has been spent?

Count the number of questions you answered “yes” to and write that number below

______________

There is no score to determine how “good or bad” your situation may or may not be.  Obviously, the more questions answered “yes”, then the more work will need to be done to improve your financial health.  Isolate the problem areas.  What action steps can be done to transition that yes to a no.  Record the number of “yes” responses.  Map out your action plan and take the assessment again in 6 months.  Has the number of “yes” responses gone down?

At one point, I answered yes to over half of these questions, I am happy to report that today I can answer “no” to all of the above questions.

If you answered yes to most of these questions, you may want to contact a professional debt management company.

It’s your turn!

What additional questions would you ask?  How would you rate your “debt health”?  Good, fair, poor?
Do you know someone in “poor financial health?  What can you do to help them?