Get With The Plan: September 29, 2013

Tia, 30, doesn’t know how she can dig herself out of a big, fat debt hole. She owes $20,800 in credit card debt, plus an additional $10,000 in college loans.

“I’m trying to stop the bleeding. I had lost my job and didn’t work for a year — I moved back home with my parents and charged my living expenses,” she said. “I had no savings except for retirement, and I took some of that out to pay bills.”

Now Tia is working again, and her nondebt expenses are low because she moved back home with her parents.

But that’s going to change soon, too. She is getting married in a year, and her fiancé is worried about how her debt might affect his credit rating.

Tia still has $7,200 left in 401(k) plans, and just $100 in her checking account.

The Star-Ledger asked Lisa McKnight, a certified financial planner with Lassus Wherley in New Providence, to help Tia create a debt repayment plan and to set her finances on a positive path for the future.

“She appears to have reduced annual lifestyle expenses within a reasonable range relative to her income,” McKnight said.

Because Tia is getting married in a year, her financial situation will change. For that reason, McKnight recommends a full-court press to pay off the credit card debt and return to financial health before the wedding.

“The objective is for Tia and her new husband to be free of credit card debt so that they can have a fresh start for their life together,” she says.

The strategy to pay off debt will be centered on using her cash flow surpluses each month. Tia has been successful in negotiating lower rates with the credit card companies.

“Tia has done the right thing by calling the credit cards and asking for a lower rate,” McKnight says. “A five-minute phone call can save hundreds or even thousands of dollars in interest charges.”

Tia was able to lower the interest rate on a Visa account with a $4,400 balance to zero percent for three months, and a Discover card with a balance of $7,000 to 9.9 percent. The remaining card has a 14.9 percent rate and a balance of $9,400.

McKnight said she should first pay off the zero percent debt before it jumps to a higher rate.

Making minimum payments is hardly enough for cardholders carrying hefty balances, McKnight said. In fact, if you make minimum payments you will probably end up spending more on interest than you do on the actual principal charged, she said.

For example, if you have a $7,000 credit card bill that’s charging 18 percent interest, and you only make minimum payments, you will end up paying a total of $10,115 interest and it will take 347 months to pay off.

Based on Tia’s cash flow, McKnight recommended she make monthly payments of $1,467 toward the zero percent card, $848 toward the 14.9 percent interest card and $615 toward Discover.

“The total monthly credit card payments will be $2,930,” she said. “This payment schedule will allow for the credit card debt to be paid off in approximately one year.”

The critical component is the commitment to pay down debt and not incur additional debt, which will thwart her efforts and slow down any forward momentum.

Going forward, Tia should use one credit card and charge only what she can afford to pay on a monthly basis.

It may make sense to keep the other accounts open, though, because closing cards can have a negative impact on her credit score.

By September or October 2014, McKnight said, the only remaining debt will be the college loans.

“If it takes longer than our projections, she should not give up, get discouraged and revert to bad habits,” McKnight said. “Resist the temptation. There’s no getting around the fact that digging yourself out of debt is hard work. So pat yourself on the back for taking on this difficult task. Notice how your credit card balance goes down each month. Enjoy these small accomplishments. Know the end is in sight.”

Tia also should shop around to see if there are balance transfers worth considering to get even lower rates.

McKnight said it’s important to keep in mind that the reason why Tia’s debt was incurred was because she had no emergency reserves to see her through a financial rough patch when she lost her job. She used her 401(k) and credit cards as a bank to pay her living expenses. For that reason, it is imperative she establishes an emergency fund, McKnight said.

“An emergency fund is an easily accessible stash of money for use only in case of emergency,” she said. “We normally recommend that individuals maintain an emergency fund of at least three to six months of basic expenses.”

For Tia, that would be $5,000 to $10,000 that she should keep in a highly liquid fund such as a money market.

“The aggressive pay down of debt will eventually free up additional cash flow once some of the credit card debt is paid down,” McKnight said. “Beginning in 2014, Tia should be able to generate enough surplus cash flow to fund an emergency reserve of $8,000 to $12,000.”

She suggested Tia put aside $1,000 a month. McKnight said Tia’s expenses will be changing, so she might not be able to save that much per month, but once the credit card debt is paid, Tia should strive to save as much as possible to her emergency fund.

McKnight also said Tia is doing the right thing by holding back on 401(k) contributions so she can earmark all her spare money for paying down her debt.

“You’d have to make more than 20 percent after tax return on stocks, bonds or mutual funds to make them a better investment than paying off a credit card with an interest rate at 15 percent,” she said.

There’s one exception, McKnight said. If your employer offers matching funds, even if you have debt, it makes sense to contribute enough to get the match because that’s a guaranteed return on your investment.

Once the debt is paid off, Tia should max out her 401(k).

“As she approaches her wedding date, she and her soon-to-be husband need to review their overall financial situation to update and plan for their future together,” McKnight said.