Getting Out of Debt: Part 2

By pgm on Aug 12, 2008 in Financial Planning

This is the fourth of a five part series on ‘Getting out of Debt’: Go to Part 1, Go to Part 2,Go to Part 3, Go to Part 4, Go to Part 5.

Find Out Who You Owe

The first step in getting out of debt is to find out who you owe and how much you owe. Get out all of your credit statements.

Name of creditor
Creditor’s address
Creditor’s telephone number
Your account number
Collateral (property such as your home, car, land, jewelry, or other assets that secure any debt)
Interest rate
Balance owed
Remaining number of payments
Monthly payment
Payment due date
Amount last paid
Date last paid
Type of legal action taken, such as garnishment (a court order that requires your employer to pay up to 25 percent of your salary directly to thecreditor) or repossession (the creditor takes possession of the property you used as collateral for the loan). If you financed a car, it is likely that the car itself would be the collateral.
Collection agency or attorney and the contact information. Once a debt has been turned over for collection, all of your correspondence should bewith the collection agency or lawyer handling the collection. Be sure to keep receipts or cancelled checks of all amounts paid to be sure that the proper amounts were reported to your original creditor. This is especially important with student loans.

Decide How Much You Can Pay Back

Now you know who you owe. Figure out how much you can pay to each creditor and decide how long it will take to pay back each debt. Generally it is good to limit the amount of credit payments (excluding your home mortgage) to no more than 15 percent of your monthly take-home pay. If your family brings home $1,200 a month, try to keep your credit payments under $180 per month ($1,200 times 0.15 equals $180). But if you already have numerous debts, figure out a way to use 25 percent of your monthly take-home pay for paying back your monthly debts. You usually need 75 percent of your income to maintain your necessary daily living expenses. A family earning $1,200 a month will probably need to keep $900 ($1,200 times 0.75 equals $900) for basic living expenses, including savings for an emergency fund. That leaves $300 ($1,200 times 0.25 equals $300) for debt repayment. If the minimum monthly payments add up to $396, you must try to increase your income or decrease your living expenses. (See Cutting Costs, VCE publication 354-155.) Several options may help you repay debts on a monthly basis.

Option 1. Keep a record of your current income and living expenses for a month (Worksheet B). Look for ways to reduce your expenses so you canuse the extra money to pay back your debts.
Option 2. Consider selling assets. What assets do you own? Do you have a television, furniture, stereo, car, jewelry, or antiques that you couldsell? Could you cash in or borrow against the cash value of your life insurance policy? Could you borrow against retirement funds? Do you have a savings account or stocks and bonds you could cash to help pay off your debts? Only use IRA or retirement funds as a last resort because you must pay a 10 percent penalty plus income taxes if you withdraw before age 59 1/2.
Option 3. Increase your family income. An extra paycheck will help maintain your present lifestyle while you pay back your debts. However,additional money will not cure poor management habits. Here are some ways to add extra dollars to your budget.
- Take a second job or work overtime to get through the financial crisis.
- Nonworking family members could find jobs to help increase family income.
- If a family earner is disabled, disability insurance payments or worker’s compensation may be a temporary solution for increasing income.
- Develop personal talents or skills to increase family income. For example, learn to wallpaper and paint your house. This service will save yourfamily money. You could also provide this service to others to increase family income. You could trade your skills for a neighbor’s skills, by providing child care in your home in exchange for automobile repair services, for example.
Option 4. Loan consolidation, home equity loans, or refinancing your home are ways to avoid repossession or loss of income through wagegarnishment. These options may reduce the amount of your monthly payment. However, the cost of borrowing is generally increased because you probably will be borrowing at a higher interest rate. If you can manage to pay your debts without loan consolidation, home equity loans, or refinancing, you will save yourself extra expense. Remember, however, that using these options generally does not improve poor money-management habits and the reduced monthly payment may encourage you to acquire more debt.
Option 5. If your retirement plan at work allows you to make changes to the amount you contribute, you may be able to reduce your portion of the contribution at the beginning of the plan year. This may cost you part of the match from your employer and reduce the amount you have saved over time, but it will increase the amount you receive in your paycheck. You need to be aware that these changes usually must stay in effect the entire year. In addition, since the money will no longer be tax deferred, you will not receive the full amount of the change in your pay check as your federal and state withholding taxes will increase. The increase in taxable income may also put you in a higher income tax bracket, causing you to owe more in federal and state income taxes at the end of the year.
Option 6. Another way for you to increase your income is to be sure that you adjust your W-4 form to have only the tax you need taken out of yourpaycheck. If you receive a large refund, you are making an interest-free loan to the government during the year. By adding exemptions on your W-4 (these do not have to agree with the number you claim on your tax return), you can increase your take home pay. Take care that you do not make the number of deductions so high that you owe taxes at the end of the year. If you receive an Earned Income Credit, you may qualify to have part of that credit in your paycheck instead of waiting for your tax refund. To take advantage of these strategies you may want to contact the VITA (Volunteer Income Tax Assistance) program.Contact the Department of Taxation for a VITA program in your area. If you are a senior, contact the American Association of Retired Persons for assistance in preparing your tax returns. These groups may also identify additional tax credits that you are entitled to claim or withholding that can be refunded if you file a tax return.