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The plan



Cut the spending deficit. Cathy’s plan must start with bridging the wide gulf between her monthly income and monthly expenses. Recently, she increased her paycheck withholding, but she should be reducing her paycheck withholding. She claims her daughter as a dependent every other year, and 2007 is a year she gets to claim her, which will result in a larger tax refund. With all of the borrowing Cathy is doing to make ends meet, it’s silly to have additional money withheld and wait on a big tax refund next year. Case in point, she received a $1,800 tax refund last year and that was the year she didn’t get to claim her daughter as a dependent!


Cathy Failor




The challenge:
Upside down in home with an ARM and home equity loan; income shortfall every monthThe plan: Boost income and slice spending to cut debt load and free up equity.

After adjusting her tax withholding to an appropriate level, Cathy must slash expenses in an effort to pare the $500-plus monthly deficit. Halt the 401(k) and IRA contributions. She won’t be passing up any free money as the employer match doesn’t take effect until January 2009. While it pains me to recommend this step, it is a testament to her need to eliminate the monthly red ink and reliance on debt.

Next, sell the time share! The last thing she needs is a money pit like that chewing a hole in her monthly budget. She spends roughly $134 per month on the time share, between the loan and the maintenance. She only uses it sporadically. Regardless, this is something she simply cannot afford.

To that end, it is important to do the following.

Trim household expenses — some radical steps will be needed. Pack, rather than buy, her daughter’s school lunches. Institute a modest allowance and shift some of the decision-making on her daughter’s purchases and entertainment to her daughter. Suspend the charitable giving and the satellite TV. (Hey, I’m serious about this!) Get a better grip on miscellaneous expenses and ATM withdrawals by slashing this in half.

All of that will get her back to break even. Then, stop using credit cards!

Debt overload
Home equity plan $33,000
Credit cards $11,000
Personal loan $13,000
Auto loan $6,000
Total $63,000
*plus a mortgage

Drowning in home debt: ARM + home equity loan

Getting back to break even every month is one thing, but what about the inevitable payment increase on her mortgage in March 2008?

If current interest rates were to hold into next year, Cathy’s monthly payment would rise approximately $105 next March. Her mortgage is a 5/5 ARM, meaning that after the March 2008 rate reset, her payment will remain the same for another 5 years.

Because she owes more than the home is worth, refinancing isn’t currently in the cards. This might change, however. Fannie Mae and Freddie Mac have announced new loan programs designed to help borrowers like Cathy. She must keep making the mortgage payments on time to have the option of utilizing one of these programs for a potential refinancing later this year. Should such a refinancing opportunity arise, she should seize it.

Possible relief on horizon

For example, if Cathy were able to refinance both her mortgage and home equity loan at a rate of 7.5 percent, she could save about $130 per month and add some much needed stability to her monthly budget. The benefit would come from spreading both her first mortgage and high-rate home equity loan over 30 years. While this would substantially cut the interest rate on the home equity portion of that debt, a rate of 7.5 percent is about what she can expect when her mortgage resets next year. If her lack of equity cushion prevents her from refinancing, she should be fully prepared for the alternative scenario of seeing her payment rise following the adjustment next March. That means finding a way to carve another $105 per month out of expenses between now and next March.

Create more family income

With limited ways to further cut expenses, Cathy needs to boost her income. She might consider working overtime or a second job. Or, do additional work from home, such as tutoring, transcribing legal documents, consulting and participating in focus groups and research surveys. Hold a yard sale to sell unneeded possessions.

She could consider renting out a room in the home to a trusted friend or relative. Or rent out the entire home if she could move in with a relative or friend for low or no rent. For example, if Cathy could rent the home for $1,000 and pay someone else rent of $500 per month, she’d bring in an additional $500 per month. Unfortunately, if she does rent her home, she is unlikely to command a rent high enough to cover all the costs because of that burdensome home equity loan.

Aggressively tackle debts

With more money coming in every month, there are two ways she can attack the debt.

Because Cathy owes more than the home is worth, she could make reducing the balance on the home equity loan the first priority for any additional cash she raises. She’ll need to create equity in her home to have any hope of refinancing. She’ll need to reduce the balance by $10,000 to $15,000 in order to refinance.

Conversely, if she foresees next year’s payment increase of more than $100 per month on the mortgage as manageable, then the strategy changes. After all, that mortgage payment will be fixed for the ensuing five years following the adjustment.

In this case, the focus should be to devote every resource to paying off the $13,000 personal loan at 21 percent. Scraping together an additional $400 per month through pay raises, overtime and additional income would enable her to pay that loan off in less than two years – just in time to become eligible for the employer 401(k) match in January 2009. Eliminating that $375 per month payment will give her a bit of breathing room to accelerate the credit card repayment, contribute toward retirement, and build a savings cushion – but only if she can hold the line on expenses!

Cathy has a long road ahead and progress will be best marked in stages. The first step is to eliminate the $500 monthly deficit in her budget and get back to break even by aggressively slashing expenses. The next stage comes when she can pull together additional income to make headway against her debt. Only then, after a period of demonstrated cost-cutting and sacrifice, will she be in a position to start building a financial future through regular savings and the reinstatement of her retirement contributions. The first order of business, though, is to aggressively cut expenses in a bid to get out of the hole that gets $500 deeper every month. If Cathy thinks this is not attainable, she should consider debt counseling as an alternative.

The plan in 4 steps
1) Stop charging up credit cards.
  • Reduce paycheck withholding.
  • Work some overtime or take a second job.
  • Sell the time share.
  • Stop 401(k) contributions (for now).
  • Suspend IRA contributions.
  • Suspend the 529 college contributions.

Tips:

5 frugal tips for 40-somethings

2) Create a written spending plan and follow it.
  • Get on a budget and follow it.
  • Slash miscellaneous spending by half.
  • Give daughter a modest allowance.
  • No more satellite dish.
  • Suspend charitable donations.

Tip:

Create a budget work sheet

3) Raise cash to zap credit card balances.
  • Reduce home equity balance.
  • Pay down high-interest loan balance.
  • Stop using credit cards.
  • Put all extra income and cash against card balances.
  • Free up equity in the home so a refinance is possible.

Tool:

Debt paydown calculator

4) Build an emergency savings account.
  • Investigate the new programs from Fannie Mae and Freddie Mac for loan refinancing.

Tip:

Crunch the numbers to see if a refi is wise

This report was prepared by Bankrate Senior Financial Analyst, Greg McBride, CFA.

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