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The Great American Debt Disaster... the modern day financial fiasco

by June Walbert, USAA Certified Financial Planner, Courtesy of USAA

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In recent history, many Americans have turned their finances into shambles through credit abuse. The Great Recession, however, brought back into focus the importance of cleaning up individual balance sheets.

Great American Dept DisasterThe Federal Reserve reported that revolving consumer debt soared to almost one trillion dollars in 2008. In November 2010, it dropped to under $800 billion.

Shedding a couple of hundred billion in debt is good for American families, and good work is being done. According to TransUnion, a credit reporting agency, at the end of 2010 the average credit card borrower debt dipped below $5,000 for the first time since 2002. Clearly a better situation, but the problem is far from gone.

Understanding how to avoid debt, dig out of debt, and properly use credit and resources available if you can’t cope on your own are important steps to coming out on top.

Dodge debt - A budget is the key. Whether bringing in $50,000 or $500,000 it’s critically important to know how much is being spent and on what. Otherwise, it’s nearly impossible to meet financial goals. Avoiding debt begins and ends with spending less than you earn.

Start the budgeting process by tracking spending for one month. For cash purchases, carry an envelope for receipts and then categorize and add them up every few days. A traveling spending log can also work. For debit and credit card purchases, many banks may give you a jumpstart by categorizing spending. It’s not important how you get there, but the end result is critical; understanding where the money is going each month.

Subtract from take-home pay, fixed and reoccurring expenses - such as mortgage/rent, car and student loan payments, utilities, groceries, et cetera, and see what is left. Where the rubber meets the road is deducting discretionary expenses discovered in the spending record - the cups of coffee, lunches out with friends, and dinner parties. Is there more money than month? If that’s the case, or if there is just a need to find additional money to direct to knocking down your debt or building your savings, work to uncover those opportunities is underway.

Formalize the budget by using various software programs, or just a legal pad and a sharp pencil. Both work fine.

A contingency fund is a critical part of being financially healthy. A cash stash equivalent to about six to nine months of living expenses is a savvy way to avoid piling on debt if Murphy shows up on your doorstep. This is how you pay for that plane ticket today for the unexpected need to fly home tomorrow. Or replace the hot water heater. A firm budget and a robust emergency fund are central to avoiding a debt disaster.

Get out the shovel. The hard truth is avoiding debt is no longer an option for many and the focus is on eliminating what debt they have. The first step on that journey is to gather and open statements. Next, highlight the pertinent details, such as current balance, credit limit, interest rate, and minimum payment due. Now, rack and stack with the highest interest rate bill on top.

Armed with the data, develop a card-by-card plan of attack. There are two separate and distinct approaches to tackling debt in this way.

The one that makes most mathematical sense is to pay as much as possible on the card with the highest interest rate while paying the minimum on the others. Zero out the first card and then take that dollar figure and apply it to the card with the next highest interest rate while continuing to pay the minimum on the other cards - minimizing the interest paid.

However, some people need a quick win. Take the opposite approach by focusing on the smallest balance card while paying the minimum on the other cards. This means paying a little more interest, but this tactic shows quicker results.

Get credit smart. Not all debt is bad. Using credit for large purchases like a home or car is necessary because not many people can buy a car, much less a home, out of pocket.

A stellar credit history is key to securing a low interest rate whenever and wherever you use credit. The credit score is possibly the most important three-digit number in a person’s financial life. Banks and lenders use those three digits to determine if they’ll make the loan and, if so, at what rate. The typical range is 300 to 850 - the higher the better - with the average American carrying a score in the upper 600’s. To get the best deals, maintain a score well over 700.

Here are the secrets to improving or maintaining a good credit score:

- Credit balances should never exceed 30 percent of the maximum allowable balance. This counts as 30 percent of your score. For example, someone with a $10,000 credit limit should not owe more than $3,000.

- Make your payments on time every time. This is critical to prove credit worthiness and counts as 35 percent of the score. Making online payments can make this task easier, putting it on auto-pilot.

- Time does matter. A long credit history is better -- accounting for 15 percent of the score. Keep the old card and the history that comes with it, using it periodically, paying it off and keeping the credit score moving north.

- Don’t fall for the department store line: “Save 20 percent today by opening a credit card with us.” To turn a phrase, just-say-no and move out smartly. Credit inquiries account for 10 percent of the credit score and more is not better. Don’t apply for unneeded credit.

- Finally, 10 percent of a credit score is determined by the mix of credit. Successful management of a combination of mortgages, installment loans and revolving credit generally results in a better score.

Call in the cavalry. It’s very tempting for many to turn to debt settlement. “Settling” with the bank or lender for less than what is owed, however, can destroy a credit score, leading to higher costs via higher interest rates on mortgage, auto loans and future credit cards. This action can also handicap the ability to get credit in the near future. Additionally, the “forgiven” amount will likely be viewed as taxable income; ruining your credit and incurring a tax bill.

Debt consolidation is usually a better option for most people. Packaging all debt into one loan with a fixed payment and beginning and end dates may sounds great, unless you continue to find those zeroed out cards too tempting to resist. Spending must be under control or those balances will go up again, along with the new consolidation loan.

Ask for help. Debt can be overwhelming, depressing and certainly stressful. Seeking guidance through the National Foundation of Credit Counseling, NFCC.org, can be a comforting and effective way to get back in the financial driver’s seat.

In the end, no matter what advertisers say, there is no silver bullet to fix the hole dug over years. A lot of discipline, hard work, and attention to detail is what rights the financial ship. The first step is the hardest and there probably will be a few stumbles. Get back on track for the long term. After all, financial freedom is the destination.

Return to September/October 2011 Issue