Drowning in plastic debt?

Wendy Reck

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The Plan

Curtail credit card spending.
Stop using credit cards! Put them in a cup of water and freeze them. Better yet, cut them into tiny pieces. Leave the accounts open, but eliminate the temptation the cards present. It isn’t wise to close out the accounts while still carrying a balance as this might trigger a punitive interest rate from the issuer. Also, should the debt-to-available credit ratio rise suddenly, this could lead to punitive interest rates on other cards or could prevent a balance transfer at an attractive interest rate later on.


The challenge: Overwhelmed with credit card debt. Living paycheck- to-paycheck.The plan: Reduce debt by selling assets and trimming expenses.
Follow-up: Chipping away at debt and feeling more in control.

Use cash or debit cards instead of charging. Even check writing has gotten Wendy into trouble by triggering an overdraft loan at 14 percent interest that will take another two years to pay off.

Credit card debt isn’t her only problem. Overspending coupled with a lack of savings perpetuates the debt cycle. That’s why I am not going to recommend using a home equity loan to consolidate this debt. Until she demonstrates a commitment to live within her means and dedicate herself to debt repayment, such a move is likely to backfire.

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

Create a budget. Begin tracking every expenditure. Money is disappearing via ATM withdrawals and the debt load is a direct result of overspending. Wendy has done a good job of recording much of what she spends but it must be taken to the next step — reconciling that against a monthly budget and the money coming in. She needs to focus on living within her means and throwing as much money as possible against her debt.

Speaking of debt, paying down the credit cards is Wendy’s new mission. Any time Wendy feels the temptation to spend money she doesn’t have, she should look herself in the mirror and ask out loud, “How committed am I?”

Be debt-free in 18 months

Immediately stop the I-bond purchases through payroll deduction. Instead, make regular contributions into a liquid, high-yield savings account.

Wendy can eliminate the $17,000 of unsecured debt in 18 months if she commits to sacrificing enough to do it. Here’s how.

Sell the individual stocks held in the taxable account and use the proceeds to pay off the Sam’s Club credit card. She has a lot of credit card debt costing in excess of 20 percent annually and the balances are going nowhere. Selling the securities will trigger a small capital gains tax bill that will need to be paid this time next year, so boosting the savings cushion will also be a necessity.

Wendy can truly accelerate the debt repayment by terminating the modest life insurance policy on her husband. This policy has a surrender charge that will remain in effect for another 11 years. The current cash value, net of the surrender charge, is $4,600.

Here are a couple considerations before taking this step. If she still wants an insurance policy on her husband, she can see if the accumulated cash value is enough to pay the premiums. This way she wouldn’t have to pay out-of-pocket and could use the payroll deduction of $900 per year to reduce debt. She may, instead, opt to replace this coverage with a lower cost term policy. Or, because she is the primary breadwinner and they have no dependents, she may decide to skip such a policy altogether. — My thanks to Ed Graves, associate professor of insurance at The American College, for his help in clarifying the workings of cash value life insurance.

Keys to success
  • Create a process for tracking every dollar spent and made.
  • Consistently spend less than you make.
  • Don’t use credit cards to bridge the gap between income and spending.
  • Paying more than the minimum is vital to cutting interest charges and ultimately getting out of debt.
  • Have money directly deposited each pay period into a high-yield savings or money market account.
  • Create an adequate cushion: at least three months worth of expenses or a sum equal to six months of expenses for households with one primary wage earner.
  • Live within your means and devote at least 10 percent of your income to investing for the future rather than paying for the past.

If she terminates the policy, she could use the net cash value proceeds of $4,600 to pay off the Target card, the overdraft loan and put the remaining $500 into her savings account. Remember that $900 per year in premiums for that insurance policy? This, too, can be used to boost that much-needed emergency savings account.

At this point, she will have paid off more than $5,500 in debt, boosted her savings account balance and will have $412 per month to cover the minimum on the Chase card with the remainder being used to pay down the Union Plus card.

But now the real work begins. To keep progressing on the pathway to being debt free, Wendy must raise additional cash by cutting expenses, selling unneeded possessions or working overtime. All of this extra money raised can be used to attack the debt on the two remaining credit cards.

Where does she begin?

Discontinue cash gifts to help out family members and consider ditching some of the extras, such as satellite TV. While it may not seem like a luxury because they live in a rural area, it costs nearly $900 annually.

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Be savvy with taxes to create retirement account. While they’re at it, they should sign up for retirement plans at work. How are they going to pay for this? By adjusting their tax withholding so their net pay is unaffected. It makes no sense to wait all year for that sizable tax refund while they’re borrowing at every turn. On the retirement plans, it may make sense to contribute only to Phil’s right now if that enables them to max out any employer match. Don’t leave any free money on the table! They must establish the habit of saving pronto.

Continue making the minimum payment on the HELOC for now. I’d like to see Phil and Stacey eliminate the debt on the two credit cards and demonstrate an ability to live within their means – which means adding to savings while paying down debt – before taking on more home improvement expenses. The only debt they should add in the next year is for Phil’s remaining tuition payments, which should be done via lower-rate student loans rather than credit cards.

The family has two life insurance policies that it pays to terminate, one on Stacey and one on their oldest son. Both of these policies have accumulated a cash value, but neither of these policies is necessary. For each, find out the surrender charge before terminating, but the remaining cash value can be used to boost savings and pay down debt. The monthly savings could be used to add an additional 10-year term policy of $150,000 on Phil since he is the family’s primary breadwinner, or investigating disability coverage, which they currently do not have. As with Phil’s existing policies, these should be paid for via payroll deduction.

Future looks bright

Once Phil graduates and secures a promotion, they can further accelerate the repayment of credit card debt, boost their retirement contributions further and dip their toes back into the home-improvement waters. But the key will be paying those renovation expenses out-of-pocket, rather than stacking it on the home equity line.

Other winds of fortune will blow their way in the next year. Orthodontist payments for the oldest son will stop in August, giving them a six-month reprieve before their daughter starts treatment. Also, Phil’s car will be paid off in another year, freeing up additional room in the monthly budget. Using those months to increase their savings cushion is vital in the event they incur any car repair bills or to make a down payment when they next decide to purchase a car.

The next 12 months could be very big for Phil and Stacey in terms of making financial headway, but it won’t be easy. It will mean some tough decisions on spending, and I know Phil won’t want to let the home remodeling project sit idle. The toughest part will be getting started. But if they focus, they will make significant progress. I look forward to revisiting their situation later this year. Good luck!

The plan in 6 steps
1) Get on a budget.
  • Track every dollar that comes in and goes out.
  • Cut miscellaneous spending to a maximum of $500 per month.

Tools: Use this work sheet to create a budget.

2) Establish a savings cushion.
  • Postpone completion of the home remodeling.
  • Open high-yield savings account.
  • Put the extra money from paid-off orthodontist bill and credit card in this savings account each month.

Tip: Find high-yield savings account.

3) Refinance into a 30-year fixed rate mortgage.
  • Check current mortgage for prepayment penalty.
  • Better define spending through a written budget to make room for a mortgage payment.
  • The payment on fixed rate mortgage will be larger, so shop carefully for best rate.

Tip: Find best fixed rate mortgages in your area.

4) Start saving for retirement.
  • Stacey and Phil sign up for employers’ retirement savings plans.
  • Money for the contributions will come by reducing their tax withholding. (This enables them to save for retirement today rather than waiting on an oversized tax refund next year.)

Tools: This retirement calculator will motivate you.

5) Eliminate all credit card debt.
  • Use all of the tax refund to pay off the credit card with the expiring promotional rate.
  • Stop buying on credit. Put credit cards away.
  • Put extra money from paid-off orthodontist bill and other reduced spending against remaining card balance.
  • Use savings from reduced spending toward credit card balances.
  • Take out a student loan for Phil’s remaining tuition rather than charging on credit cards.

Tools: What will it take to pay off my credit card?

6) Change up life insurance policies.
  • Cash out the unnecessary life insurance policies.
  • Use the remaining cash value to boost savings and pay down debt.
  • Add 10-year term life insurance policy on Phil.

Tools: How much life insurance do you need?

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

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