If you’re just stopping by for the first time, this is a class in a series of classes over the next few months which will culminate in the development of a complete financial plan.  Stop by the orientation class HERE first for class orientation/overviews and HERE for more information about the website.

Class Objectives: To understand the definitions and terminology used with debt and to learn about and create a plan for paying off revolving debt, such as credit cards.
Prerequisites: PF101: Intro to Personal Finance & Goals, PF102: Creating a Net Worth Statement and PF104: Creating a Budget & Cash Flow Statement
Handout: Why and How to Get Out of Debt
Assignment: Credit Card Payoff Schedule in Excel| Google Docs (previews in lecture material)

CLASS LECTURE

Debt, of course, is simply owing someone else money.  It seems like every other personal finance post I come across is a debt success story with the title “How I paid off $x,000 in xx days” or some variation of that statement.  Paying off debt is a popular topic and there are some awesome people out there sharing their examples of how they got tired of being in debt, committed to paying it off and then worked as hard as they could to get it done.  We’re going to talk more about the basics of debt and make a plan for getting out of credit card debt.

What do you think of when you hear the word “DEBT”?  A credit card?  A house with a mortgage?  Stress?  Chains?  I personally think of my mortgage when I think of the word debt and how someday I would like to live totally debt-free, including paying off my mortgage.  That will take us some time, since we recently purchased and are doing a major renovation on a new home, but it’s definitely one of my goals.

We aren’t go to go too much into most of the debt terminology, but I do want to look at a couple of terms regarding debt.

GOOD vs. BAD DEBT

The term “good debt” is really a lie, because all debt is inherently not “good”, but I would definitely agree that some debt is bad and some is not as bad.  Buying the house we wanted with cash wasn’t an option, so a mortgage was the tool we needed to help to fund it.  Being able to get a graduate degree required me to borrow some money to pay part of the tuition (although we were able to get both of our bachelor’s degrees debt-free!), so a student loan helped me to achieve that goal.  Unfortunately, that meant that we owe someone (lots of bank shareholders in fact) a lot of money, but we are comfortable with it since we believe that it will appreciate over time.  Someone wanting to start a small business may also incur debt, which will (hopefully) be instrumental in helping them grow their business to the point that they wouldn’t be able to without the extra help.

Bad debt is debt that incurred to purchase assets that are quickly used up or depreciate.  This includes autos, boats, household goods, clothing, groceries, etc. Credit card debt is definitely a bad debt, regardless of what type of expenses you have put on your cards.

You certainly know that people have very strong opinions about credit cards.  Some people say they’re a great tool for earning rewards, others say they are the root of all evil and that they should all be cut up.  I personally believe that there is no across-the-board answer but that it depends on the individual and what their spending and paying habits are.  As for me, I use my credit card for nearly everything and I pay them off in full every single month.  I haven’t carried a balance on my cards for more than a month ever in my entire life, and I have a separate emergency fund to cover unexpected expenses.  The only reason I use the cards is for the rewards, perks and security and I don’t feel that I overspend because I track each and every expense and use this one little trick:

I never look at my bank account balances without looking at my credit card balances as offsetting cash.

If I want to know how much cash I have, I add up my accounts and then subtract what I currently owe on my credit cards (like I said, these are all current expenses and I do not carry a balance from month to month).

However, I do think credit cards are not for everyone, especially if you have a history of trouble with debt.  If you currently carry balances on your credit card, you should STOP using your credit cards, pay them off, and change your spending habits for at least 6 months before even considering them again.  Or if you know that it’s a problem for you, never use them again.  The 1-2% rewards just aren’t worth the 20% interest rate, seriously.  That’s basic math.

Credit cards are bad because:

• The interest rates are exorbitant.  Seriously, the average annual interest card rate is around 20% for a cash back credit card.
• You will pay this interest rate FOREVER if you are only making the minimum payment.
• You could essentially be doubling the price of the goods you are buying if you have the average interest rate and are making the minimum payments.
• You are already assigning your future income to past expenses instead of to your future goals.
• It’s like having a negative emergency fund.  If you have a layoff or unexpected reduction in income, you have a current debt that you won’t be able to pay.

“Good” debt includes debt that is essentially an investment tool to earn money in the future.  Some examples include:

• Student loan debt – see my post here for the correlation between net worth and education level.  Most people need a student loan to be able to afford college and especially for advanced degrees.
• Home mortgage – ideally, your home value goes up over time and your home is a type of investment.  A nice home in a good location also can mean better schools for your children, a safer neighborhood and many other invaluable things.  There’s a balance of course, though and you don’t want to have a mortgage payment more than you can afford.
• Investment debt – this debt, if at a lower interest rate than you what you can make if you invest can be a wise decision for some people.  I personally prefer to be debt-free rather than be able to make more money, because I value freedom more than increased wealth.

REVOLVING DEBT vs. NON-REVOLVING DEBT

Credit card debt is an example of revolving debt.  You pay off old debts, but create new debts at the same time if you are regularly using them.  Additional examples include a home equity line of credit and other personal lines of credit.  The balance keeps revolving and new expenses replace old expenses.

Non-revolving debt examples include installment loans such as mortgages, home equity loans, auto loans and student loans.  You start with an original loan amount and pay it off with interest each month, decreasing the amount you owe exponentially over time.  These loans don’t revolve, because you do not ever add to the principal balance you owe.

STEPS TO TAKE BEFORE YOU START YOUR DEBT PAYMENT PLAN

Before we even start looking at creating a plan to pay off debt, there are three things that need to happen.

1. You have to be 100% committed to paying your debt.  This is why we started out in our first class setting financial goals.  You have to have goals that you want to achieve and be tired of debt getting in the way of your life.  You have to be more than tired of debt, you have to be done with your debt.
2. You need to make a list of all the debt you owe right now.  And that’s another reason that we created net worth statements in a previous class.  In addition to those balances though, you also need to find your interest rates and minimum payments for each credit card.  These will be on your monthly statements.
3. You need to know how much extra you can pay each month toward your credit card debt.  You may think that you don’t have any extra money to spare, unless you have completed the previous classes and learned to track your expenses and budget your money.  If you’ve completed your budget, then you should know how much you are able to pay.  If you can cut back on expenses, now is the time to be frugal.  Unfortunately having credit card debt means that yesterday you lived to extravagantly and today you get to make up for it so that tomorrow you can having an amazing life free of debt.  Just be sure to make room in your budget for some fun here and there, so you can still enjoy life while becoming debt free.

SCHEDULES FOR PAYING OFF CREDIT CARD DEBT

For a quick look at how long it will take you to pay off your credit cards paying different monthly payment amounts, go to  CreditCards.com.  Your credit card statements are also required to list how long it will take to pay off your balance if you make only the minimum payments and the total amount of charges plus interest you will be paying during that time.  Looking at that should help you get motivated to tackle that credit card debt!

You’ve probably heard of the debt snowball and debt avalanche approaches to paying down debt.  As a quick refresher:

• Debt snowball – This method involves paying off your balances from smallest to large, creating more momentum and keeping you motivated to pay off your debts, since you can see more tangible progress on balances being totally paid.  Once one balance is paid in full, the money you were using to pay off that minimum balance plus any extra payments you can make get assigned to the next largest debt.  This huge advantage of this method is the sense of accomplishment and motivation you have that keeps you going to pay more.
• Debt avalanche  – This method involves paying off your highest interest rate balances first.  This system decreases the total amount you will pay overall in interest and saves you time in the long run as well.  The cost savings is the main advantage of this method.

What matters the most is not the order that you paid off your debt but that you are actually paying it off!  

Don’t get too hung up on one or the other.  If you decide to go with the debt avalanche, but are getting discouraged by not seeing enough progress, you can switch your payments to pay off one of your smaller debts.  Or you could just start with a smaller debt first to get excited about it and then move on to paying off your highest interest rate debt.  I’ve created this awesome (if I do say so myself) spreadsheet (ahem…homework assignment) for you to use where you can customize the order of the payments to compare and create your own plan for paying off your debts.  I liked this debt calculator here, but I wanted to create a similar one that would allow you to change how much extra you can pay each month for those on variable income schedules that sometimes can’t pay any extra.

To use this spreadsheet, you need to gather your most recent credit card statements.  All of the information you need is readily available on the statement.  Enter the creditor name (such as Citi Bank or Chase), the current balance due, the interest rate for purchases (referred to as the APR) and the minimum payment due.  Some credit card statements will show you much interest you will pay and how many months it will take you to pay off your balance if you only make the minimum payments.  If your statement doesn’t show this information, use CreditCards.com to quickly calculate these amounts.

Enter the extra payment you can make each month in the column shown below (the example shows $100).  This can and probably will change from month to month, so that’s where your budget is essential.  Once one debt is paid off, the minimum payment you were paying on that debt will automatically be used to help pay off the next debt listed on the schedule.  The Smith family example in the next section shows this.  The total interest paid and months to pay off will be automatically calculated from the inputs, as will the month in which your debt will be paid off.  You will be surprised to see the comparison between the interest payments and number of months in which your debt will be paid off when you make even small extra payments versus making the minimum payments.  You can do this!

A few important notes about the spreadsheet:

• The debt needs to be entered in the order that you wish to pay them off (highest interest rate, lowest balance first, or a mix of those).
• Only enter numbers in the yellow highlighted cells
• This spreadsheet can also be used for other loans as well-student loans, auto loans and even mortgages.  Credit card debts should be paid off first, so that’s the focus of this class.

EXAMPLE: THE SMITH FAMILY

The Smith family already found their credit card and debt balances to complete their net worth statements in the class here.  For this exercise, they pull out their credit card statements and have found their interest rates and minimum payments for each card, as well as the total interest they’ll pay and how long it will take them to pay off the cards if they only make the minimum payments each month.  They’re entered in the spreadsheet here:

The Smith’s have decided not to put any more charges on their credit cards starting immediately and use their debit cards or cash for all purposes.  This way, they can see the balances on the cards decline and get better control over their spending habits.

As for their debt plan, they decide to pay off the highest interest rates first (Avalanche method), because their two smallest balances have the highest interest rate as well and it will help them get motivated to pay off their debt.  They have gone through their budget and decided to cut out cable, cut back on eating out, be more careful about their utility costs and put their extra student loan payment that will be paid off in July toward their credit card debt.  These changes will help them to save $200 per month through June and then $463 per month starting from July.  Their biggest choice is that they’ve chosen to cut out their vacation and instead find somewhere more local until they’ve paid off their debt (that’s a $2,000 savings in June).

Here are their debt payoff calculations.  Click on the image to see a PDF version.

By intentionally focusing on making more than the minimum payments on their credit card debt, cutting back their expenses and applying their minimum debt payments that were paid off to the next debt, the Smith family is going to be able to save $6,289 in interest and over 5 years paying down their credit card debt!

HOMEWORK ASSIGNMENT

Your homework assignment is to create your plan for paying down your credit card debt, including the payments you will make to each every month and creating a goal for the time period in which you will pay off all of your credit card debt.

• IMPROVING– Look up how long it will take you to pay off your debt at CreditCards.com and set up automatic payments to pay extra on your debts.
• INVESTED– Fill out the debt spreadsheet with either the snowball or avalanche methods and determine how much extra you’ll be able to pay toward your debts each month.
• UNSTOPPABLE– Completely fill out the debt spreadsheet and run different scenarios to see which method will optimize both your motivation in paying off the debt and have the lowest amount of interest you’ll pay overall.  Brainstorm ways to cut some areas of your budget to pay off your debt as quickly as possible and re-define your debt goals based on the information you now have.

File your debt payoff schedule in your Financial Plan binder under Tab 1-Financial Goals.

HANDOUT: HOW AND WHY TO GET RID OF YOUR DEBT

In our next class we will be discussing long-term, non-revolving debt such as mortgages, auto loans and student loans and of course I’ll have some more resources for you then!

What is your best piece of advice for paying off credit card debt?