The Magic Secrets of Personal Finance

The Magic Secrets of Personal Finance There is a magic secret that enables you get in deep financial trouble very quickly--and get out almost as quickly. This is one of those items that is blindingly obvious--and yet most people don't ever think about, until you tell them. Let's say that you are a typical American. You spend $4000 a month; you bring home $4000 a month; you have a few hundred in savings, and $10,000 in credit card debt. You never get ahead financially, but at least you aren't sinking. Then, one day, you need to replace the engine on your car--and now, to keep your monthly minimums on your credit cards, you now are spending $4100 a month. As Mr. Micawber would tell you, "result misery." You are now getting further behind every month--and in a few months, even if nothing else goes wrong, you are now spending $4150 or $4200 a month. Soon, you are beginning to watch those ads from bankruptcy lawyers. Magic Secret #1 You must, before this deficit gets out of control, either reduce your spending or increase your income enough to have a budget surplus--even a very small one. Then, once you have created this budget surplus, you must exercise great self-control, and use that surplus for one purpose alone: paying down the highest interest rate debt that you have. Consider the poor guy above. He has a $5000 balance on MasterCard A, and the rest on Credit Card B. He has a $200 a month minimum monthly balance (4% of the outstanding balance)--of which $75 is interest alone (1.5% monthly, or 18% annually). If he increases his payment from $200 a month to $400 a month, instead of paying $125 in principal and $75 in interest, he will be paying $325 a month in principal--and within four months, instead of paying $75 a month in interest, he is paying $55 a month in interest. Keep it up: in another four months, he is paying $36 a month in interest. But you must keep paying more than just the minimum monthly payment, or you are going to find out what the miracles of compound interest can do for your credit card company. Once you have wiped out MasterCard A, it's time to tackle the next one--and here's the magic trick. Take the $400 a month that were spending on paying down MasterCard A--and now apply it to the other credit card with a $5000 balance. You were already putting out $200 a month on that credit card bill, so it will shrink away a lot faster than MasterCard A. This requires a lot of self-discipline--to stop spending money on things that you don't truly need--and using the money that you have freed up from debt service to pay down other debts as quickly as possible--instead of celebrating. "Whee! I've got $400 a month freed up--I can trade in my Toyota on a Lexus!" Magic Secret #2 There I was in Irvine, with a colicy baby, a mountain of credit card debt, and a small increase in income from consulting work. What else could I do to improve my finances? Well, what kind of an interest rate was I paying on that debt? I had bought an IBM PC in 1982, back when PCs were still expensive. You young'uns can laugh, but I spent several thousand dollars for a computer with 64K RAM (that's a K, not an M), and two floppy drives. The credit card on which I purchased it was 18% APR. (I had very good credit--that's why the interest rate was so low.) What could I do to refinance it? At the time, my sister Susan was getting 9% yield on her money market funds. She was looking for a better return, and I was looking for a lower interest rate. Voila! She loaned me the money at 14.5% APR. She was now getting a better return on her money; my minimum monthly payment dropped. But instead of paying it back to my sister over the same four year repayment term as my credit card, I doubled up the payments, and paid it off in two years. Susan was richer; I was less in debt. What you need to make this work: a relative, or a close friend, who trusts you enough to loan you money unsecured. You need to offer them an interest rate that is attractive, relative to what they are getting in their incredibly boring and safe money market funds or CDs. However, the gap is still huge. My money market fund is paying me about 1.1% yield right now; my one year CDs are about 2.2%. Interest rates on credit cards are still absurd--12%-18%. Look around--you may find an older relative who has the money to refinance your debt--especially if you can make a strong case to them that this will improve your long-term financial picture, that you are going to aggressively pay down your debts--and that you aren't going to flake on them. (I've lent significant chunks of money to friends and relatives three times; once to pay for an engine repair--almost none of it was paid back; once to my brother-in-law, so he wouldn't lose his mobile home, almost none of it was paid back; once to help some people at church consolidate their debts--most of it was paid back.) By the way, this strategy really only makes sense for unsecured debt. Car loans are typically financed at rates low enough that this sort of private refinancing isn't going to be a huge win. I think that there may be some liability issues in some states as well on being the lienholder on a car. It's tempting to use this strategy for putting together the down payment on your first house. The problem is that increasingly, lenders won't allow it--the money has to be a gift, not a loan. My mother was willing to loan us the money for our first house, and did so, but fortunately, by the time we were ready to plunk down the cash, the strategy above had cleaned up our debts to the point where we were able to pay her back, and do the down entirely on our own.