Monday, February 16, 2009

Become debt free

John Steinbeck's The Grapes of Wrath depicts the hardships the Okies endured during the Great Depression: starvation, squalor, and general misery. This misery was made much worse by two things: (1) the fact that they didn't own their homes outright, and (2) their mule-headed determination to rely on the credit-based economy. They would have had problems during the Great Depression, but not to nearly the same extent if they had owned their homesteads outright.

The same goes for everyone, whether we are in an economic downturn or not. So, how do you pay off your mortgage as soon as possible when you have other debts?

Of course, this plan assumes that you still have a job and that you are not stretched so tightly that you have no money for food during the last week of the month.

First, make a deliberate decision to become mortgage free as soon as possible. It should become a major life goal. Second, immediately stop spending more than you make in one month. Third, realize that this will take several years – more than a decade. Focus on your goal. Be methodical. And every time you get a raise at work, no matter how small, put it in savings and continue to live off the same monthly budget as before the raise.

This is not hard to do. But you do have to be patient because it takes several years to become debt free.

Here are the steps:

Step 1 - First make a complete list of everything you owe. Write down all your credit card balances and the minimum required payment. Don't overlook miscellaneous accounts such as doctor bills or furniture loans. Now add car loans, boat loans, and recreation vehicle loans including balances and payments. Last, add your mortgage payments and balances. Be sure to include second mortgages, lines of credit, and any equity loans.

Don't panic when you see how much you owe.

Step 2 - Stop spending more than you make. This might mean cutting back on purchases you don't absolutely need. No, you do not need that cute pair of shoes or the new dress. No, you do not have to buy the expensive cuts of meat. Decide today that you are not going to live beyond your means any more. Do not, I repeat, do not keep charging stuff to your credit cards. STOP.

Now take the list you created and rewrite it starting with the smallest balance at the top, then the next smallest, and so forth, with the largest balance (most likely your mortgage) last.

Step 3 – Free up some money for the month. You do not have to think big at this point. How much could you free up if you eat out one less time each week. If you spend $12.50 less per week for restaurant meals or by foregoing the movie theater (rent a movie instead), or not taking Sunday drives for pleasure (read a library book instead), and by brown bagging a sandwich and piece of fruit for lunch during the week, you can save at least $50 per month.

$50 per month is all you need to begin to methodically pay off your debts.

Step 4 - Begin by taking the lowest balance at the top of your list and adding the money you saved by not eating out, not taking Sunday drives, etc, to the minimum payment every month until the balance is paid off. Example: Suppose the balance is $1000 on credit card number one and the minimum payment is $15. Simply add $50 to the minimum payment for a total of $65 each month until the balance is paid in full. While you are doing this, it is important to continue making the minimum payments on all other debts.

Then, if you have more than one credit card, do not use that credit card again. Send a letter to the company asking that the account be closed. Cut up the card.

Step 5 - Once you have paid off the first credit card, start on the second. Use the whole payment you were paying on the first card, including the extra money from not eating out so often, and add it to the monthly minimum payment for card two. Once the balance is paid off, if you have other credit cards, close the account for card two.

Continue the process with credit cards number three and four, etc, until all credit cards are paid in full. Make sure you close all credit card accounts except for one MasterCard or one Visa that you use only for emergencies. Charge a very small amount each month and pay off in full each month to keep the card “active.”

Step 6 – One at a time, work your way through paying off installment loans, personal loans, car loans, and other vehicle loans while keeping in mind your eventual goal is to pay off your mortgage.

You started this program by simply eating out less, not going to the movies, etc, saving $50 per month. You added the $50 you saved to the first credit card minimum payment. Then you added the monthly payment you made on the first credit card to the second card and the second to the third and so on. After the credit cards were paid off, you added the total you were paying against your credit cards to your car loan. Once the car loan is paid off, add the full amount of the car payment plus the credit card payment toward the next largest loan. In a few years you will have become entirely debt free, except for the mortgage on your house.

Note: Once your car(s) is paid for, do not buy a new one. Keep up with the maintenance on the car you have and drive it forever – or until the wheels fall off – with 200,000 miles being your goal. Hopefully, you bought a good car in the first place. If you end up having to replace your car – buy a reliable, “certified” used car, with less than 50K miles from a dealer – for cash if possible – buying only what you can easily afford. Make sure you get at least a 90 day warranty and 30 day return policy in case something goes wrong with it.

Step 7 – Now you are ready to accelerate your house payments and pay off your home. Let's suppose by the time you finish paying off your credit cards as well as all other loans that you have gradually worked up to applying about $800 to $1000 per month to your debt reduction program. If you have a $250,000 mortgage at a fixed rate of 5.5% for 30 years, your principal and interest payment would be $1420. Take the $800 or more that you were using to pay down your other debts and apply it to your mortgage principal each month.

Here’s the catch: Make certain to instruct your mortgage company, in writing, to apply the additional payment of $1000 to principal. You should send a note with a separate check asking that the extra money be applied to your principal. If you don’t give them written instructions, they will just use the money as an extra “house payment” with interest and escrow. They will consider you to just be “paid ahead.”

In applying the extra $800 monthly toward your mortgage principal, you will pay off your home in less than a dozen years.

With patience and focus you can become debt free. And all you had to do was skip a weekly restaurant meal, ditch the movie theater, forego the Sunday drive, and brown bag your lunch.

References: Years of reading Money Magazine, Kiplinger Magazine, and Suze Ormond – just to name a few.