I once sent a credit card company $5 per day, every day, for a month.  Seriously.

The year was 2005 and I was in full on debt reduction mode.  Pumped up by the comments left by my readers – and ready to be debt free – I spent most of my waking-hours thinking about ways to reduce my debt.

Somehow, the thought struck me:  What if I manage to save $5 a day – say by skipping my morning trip to the convenience store or brown-bagging lunch – how quickly could I put that $5 to work?

I decided, just to see if it would work, to use online bill-pay to send a series of $5 payments to the credit card company.  I scheduled the payments, one right after the other, for each day of the month.  Every other day or so, I would check my credit card balance (online) and, sure enough, my balance was going down, $5 a day.

At the end of the month, I managed to reduce my credit card balance by an “extra” $150.  The silly little experiment worked!

Now, am I suggesting that anyone else do this?  Not really.  In fact, I’ve heard that some credit cards actually limit the number of payments that they’ll process during a billing period.  Nevertheless, I do think that my silly little experiment was valuable, in that it taught me the power of micro-payments.

I’ve mentioned micro-payments before – those small payments, sent throughout the month, which help to reduce the average daily balance in your account.  These payments are made after regular minimum payments and are in addition to the extra payment one might send while getting out of debt.

Not only did I learn the value of micro-payments, but I also learned that money management is about much more than just dollar signs, percentage points, and mathematical calculations.  Money management is about keeping your head in the game and staying focused on specific goals.  Each day, as I logged in to my checking account and scheduled another payment – that was one more day where I had successfully saved $5.  This $5 was above and beyond my regularly budgeted-for debt reduction payment.  This $5 required a change in my habits.

For thirty days, instead of focusing on the big-picture, I focused on the very, very small things.  If I wanted a soda, I had to remember the $5.  If I wanted a newspaper, I had to remember the $5.  If I wanted to rent a movie, I had to remember the $5.  This silly little experiment (which, in the end, wasn’t really all that sill), helped me learn the value of every dollar that comes in to my life.

If I had it to do all over again, here’s exactly what I would do – and it’s what I do when making micro-deposits to my savings account:

1.  I would set a goal of saving $5 each day.

2.  At the end of the week, I would send a micro-payment (or micro-deposit) of $35.

3.  A couple of days after sending the micro-payment, I would check my credit card balance, just for that emotional boost that comes with seeing my debt reduced.

The month after my silly little experiment, I went back to my standard practice of making my minimum payments to all accounts, making an extra payment to the first account on my debt snowball, and then I made four micro-payment throughout the month.

Micro-payments rock and they really kept me motivated. Have you used micro-payments?  If so, leave a comment and let us know about your experience!

One final note – All of these payments were initiated by me, using online bill-pay.  I never game the credit card company access to my checking account.  In other words, my bank was sending a payment to the credit card company.  The credit card company was not “pulling” money from my checking account.  And, obviously, this micro-payment thing probably won’t work if you are sending payments via paper check from your house.  The postage cost would be too high.

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How A Silly Little Experiment Helped Me Get Out Of Debt

1.  Create a list of your credit cards.

• Include account balances, interest rates, due dates, and minimum monthly payments.

2.  Make minimum payments to all credit cards, on time.

3.  Make an additional payment to one of the cards on your list.

• If you make an extra payment to the account with the smallest balance, you can quickly eliminate an entire card balance from your plan.  This may provide a much-needed emotional boost and keep you motivated.
• If you make an extra payment to the account with the highest interest rate, you guarantee that you will be paying the least possible amount of interest.  This is a mathematically-sound approach.

4.  Continue to make minimum payments and the extra payment until the first card on your list is paid off.

• If you have the chance, make additional extra payments – micro-payments – throughout the month.  This reduces your average daily balance and really speeds up the debt reduction process.

5.  Continue to make minimum payments to the other cards, and take the additional amount you were paying on the first card plus the minimum you were sending to the first card, and apply that total to the second card on our list.

6.  Repeat this process of eliminating balances until all credit card debt has been eliminated.

This debt reduction process works with any types of debt and is especially effective when dealing with credit card debt.

This week I will be writing a series of Back to the Basics articles.  I encourage you to subscribe to No Credit Needed via RSS or Email.  Also, if you liked this article, please consider promoting it via the social network buttons below.  Comments are always appreciated – and don’t forget to follow me over at Twitter.com/NCN.

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How To Eliminate Credit Card Debt

After digging and pouring the footer for our house, it’s time to set our foundation.  Our financial foundation needs to be solid, stable, and able to support the weight of our financial house.

Three components of a solid financial foundation -

Insurance

At present, my wife and I have health insurance, term life insurance, disability insurance, automobile insurance, dental insurance, and renter’s insurance.  We also have an umbrella policy that protects us from events not covered by our renter’s or automobile insurance.  In the future, we plan to purchase long-term care insurance.

Ever few years, I review my policies with a qualified professional.  My wife and I believe in several ounces of prevention.

Debt Reduction

My wife and I really enjoy living debt free.  (It rocks!)  Our hope is that we can live the rest of our lives without borrowing money.  (We might make an exception for the purchase of a house.  At present, we live in a house provided by my employer as part of my compensation.  If I were to change jobs and we were to move, we would either rent or take on a mortgage, depending on what was right for our family at the time.  For the sake of this article, I’ll be speaking of non-mortgage debt.)

If you have high-interest debt, it’s time to get angry and do something about it!  Making minimum payments and dealing with credit card companies isn’t any fun.  Make a plan, eliminate your debt, and then move on to the really important things in life.

Emergency Fund

My wife an I have an emergency fund (roughly) equal to six months worth of expenses.  We built this emergency fund immediately after paying off our last debt.  The peace-of-mind it provides is priceless.  (While we were paying off our debt, maintained a smaller emergency fund between $800 and $2000.)  The amount in an emergency fund will vary, depending of family size, location, employment situation, and comfort level.  We sleep better at night, knowing that we have an emergency fund in place.

Pouring and setting a solid foundation can be back-breaking work.  Dealing with a financial foundation can be extremely taxing – mentally and emotionally.  I know, for me, it was overwhelming when we first began the process of getting out of debt.  I was embarrassed by many of the financial decisions I had made in my past and I felt somewhat lost as to where to begin.  Thankfully, I was able to connect with some good friends who had good advice and, little-by-little, I was able to make some very positive changes.

Go slow.  Understand what you are doing.  Keep things simple.  Move forward.

Start with a good, solid foundation – and the rest of the building will (almost) build itself.

Image by barron

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Our Financial House – The Foundation

For those who are ready to get our of debt, here’s a list of debt reduction resources -

Debt Snowball Calculator over at What’s The Cost – This free online tool will help you quickly create a debt repayment plan.

iPhone and iPod Touch Debt Snowball Application – Created by Blunt Money, this application, which sells for $2.99, will help you create a debt snowball using your iPhone or iPod Touch.

Debt Reduction Guide – I created this step-by-step guide to show folks how my wife and I got out of debt.  The guide is available online – and you can also download a copy of it as a free E-Book.  It’s easy to read and free to share.

When Will You Be Debt Free? – This calculator from CNN Money is very simple to use.  Simply enter your current credit card balances, your interest rates, your minimum payments, and the date you want to be debt free.  The calculator will calculate how much extra you need to pay, each month, to achieve your goal.

Microsoft Excel or OpenOffice Calc Debt Reduction Calculator – If you prefer to work with Word or Open Office, here’s a free debt reduction spreadsheet.

Mortgage Payoff Calculator – I love all of the calculators over at DinkyTown.  This one will help you calculate the impact of extra mortgage payments.

Calculating Average Daily Balance Spreadsheet – I created this spreadsheet so that I could calculate how the timing of payments determines the amount of interest charged.  The spreadsheet works Microsoft Excel or OpenOffice Calc.

These are just a few of the debt reduction resources I’ve found (or created) over the past few years.  If you have a resource that you think would be of value to others, leave a comment and let me know about it.  (Obvious spam comments will be deleted.)

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Debt Reduction Tools And Calculators

I am a big fan of micro-payments. If you are unfamiliar with the term, a little background information might help.  Back in 2005, while working to pay off my debt, I decided to try a little experiment.  Instead of sending just one payment to my credit card company each month, I started to send several.  I called these small payments micro-payments.  At one point, I actually sent $5 a day (via online bill-pay) to one credit card company, just to see if the system would work.  (I don’t recommend sending micro-payments quite that often, and I only did it for one month, as proof-of-concept.)  At the end of the month, my balance was reduced by an additional $150, above and beyond the amount of my regular payment.

Throughout this article, whenever you see the word month, feel free to substitute the words billing cycle.

Micro-payments are simply extra payments, made throughout the month.  They are designed to reduce a credit card balance and to keep one’s mind focused on the debt reduction process.  These extra payments are additional payments, and are only made after minimum monthly payments are made (on time), to each and every creditor.  Also, micro-payments are not intended to replace debt snowball payments, but are intended to compliment those payments.

Perhaps an illustration is in order -

Assume that you have three credit cards that you are trying to pay off -

Credit Card A with balance of $5000 @ 10%

Credit Card B with balance of $6000 @ 12%

Credit Card C with balance of $8000 @ 8%

Further assume that you are using the debt snowball method to reduce your debt -

You will make minimum payment + extra payment to Credit Card A

You will make minimum payment to Credit Card B

You will make minimum payment to Credit Card C

Remember, if you use the typical debt snowball, you will pay off debts, starting with lowest balance first, regardless of interest rate.  If this method does not suit you, you might consider the debt deluge – a modified version of the debt snowball.  Use online bill-pay to simplify the process and save on postage.  When making minimum payment and extra payment to Credit Card A, feel free to send one payment, equal to their combined total.

After making all minimum payments and your extra payment, it is time to focus on micro-payments.  Throughout the month, look for opportunities to send in micro-payments, as you earn additional income, receive monetary gifts, or spend less than anticipated in certain budget categories.

Assume that in Week #1 –

You receive $25 as a birthday gift

You sell a few books online, netting $15

You ride to work with a friend, saving $10 in gasoline

At the end of Week #1, you have the following options -

You could spend the $50

You could save the $50

You can could send the $50, as a micro-payment, to Credit Card A

Since you have already sent in your minimum payments (on time) to all creditors, and you have already sent your scheduled (and budgeted for) extra payment, any of these options is available to you.  (We will assume that you already have a small cash reserve set aside for small emergencies.)  And, if you are uncomfortable sending the entire $50 as a micro-payment, you could send just a portion of the $50.

By now, you might be wondering -

Why worry with micro-payments in the first place?

Why not just one, larger, extra payment at the beginning of the month?

Why not send just one, larger, extra payment at the end of the month?

Not only am I a rational being, but I’m also an emotional being.  As such, it’s important for me to remain engaged – focused – on any project on which I am working.  When it comes to debt reduction, this was doubly-important.  Not only was I trying to do away with 15 years of negative behaviors, I was also trying to replace those behaviors with positive behaviors.  By constantly looking for ways to save money – I remain engaged.  By thinking about ways to earn additional income – I remain focused.  Just thinking about ways to save a little more or earn a little more, so that I could make a micro-payment, kept me emotionally involved in the debt reduction process, in a way that the one-payment-per-month-method never would have.

There is also a mathematical reason for sending micro-payments throughout the month.  Most credit card companies use the average daily balance for calculating how much interest they charge.  Making payments as soon as is possible will lower the average daily balance, thereby reducing the amount of interest owed.  If you save up an additional payment and the send it when you get your next bill, you might be paying unnecessary interest.  In other words, if you receive $50 as a birthday gift, and you have no real need for it, send it in as soon as is possible, thereby reducing your average daily balance.

There is an additional reason for using micro-payments, one that was very important to me while I was getting out of debt.  I like to set goals – ambitious goals.  There are times, however, when my goals are a bit too ambitious.  For instance, let’s assume that my budgeted extra payment to Credit Card A is $500.  For some, $500 might be a reasonable amount for an extra payment.  For others, $500 might be a stretch.  So, instead of sending in $500 at the beginning of the month, there might be times when it would be better to send in a $100 extra payment, and then, throughout the month, send in four additional $100 micro-payments.

This might be true, especially, for those who are paid on a weekly basis, those who have irregular income, or those who are new to budgeting.  It is very easy, especially in the early days, to over-estimate how much money you actually have for debt reduction.  We do not want to find ourselves, at the end of the month, with a need to use a credit card.  By spacing our micro-payments out, over a full month, we can better judge if our budgeted-for extra payment is practical.  If we find that coming up with $500 was easy, then we might want to send the full amount at the beginning of the month.  If we find, on the other hand, that coming up with $500 was impossible, we might want to budget $250, and the use micro-payments to send in extra, as we save it or earn it.

Please note:  Sending in a larger amount, earlier in the month, will almost always lead to a lower interest charge (provided the credit card company uses the average daily balance method for calculating interest).  Also, no matter what method you use, it is imperative to make minimum payments on time, to all accounts.

There are a few more things about micro-payments to keep in mind -

When sending micro-payments, be sure that you can comfortably keep track of them.  Online access to both your checking account and your credit card accounts is a must.  Also, the payments that I was making were initiated from my checking account to my credit card account.  In other words, these were payments, sent by me, via online bill-pay.  I did not use the credit card companies service, whereby they will deduct payments from a checking account.  For me, I never felt good about giving my credit card company, or any other company for that matter, access to my credit card account.  Four micro-payments per month, one each Monday, worked well for me.

Micro-payments can also be sent to pay off mortgages, automobile loans, and almost any other type of debt.  Just check with your creditors and ask them where to send additional payments and how to label those payments.  I always labeled mine – apply to principal.

It’s always important to have enough money to make all minimum payments.  In other words, don’t send every extra penny that you have in August, if in September, you aren’t going to have enough to make your minimum monthly payments.

Now that I am debt free, I no longer make micro-payments, but I do make micro-deposits.  At the beginning of the month, I set aside a budgeted amount for savings.  Then, throughout the month, I look for ways to save money or earn additional income.  Once or twice a month, I make additional micro-deposits to my savings account, thereby saving more, each month, than my original budget predicted.  This also works when making contributions to a Roth IRA.

Please be aware, some credit card companies may limit the number of payments that they will process in a given month.  Be aware of your credit card companies policies.  Also, be sure that you are using a free online bill-pay service to send your micro-payments,  avoid spending money on postage, and verify that your credit card company is receiving extra payments.

I would love to hear your success stories with using micro-payments.  Also, if you have any additional thoughts or tips, leave a comment and let us know about them.  Let’s eradicate some debt – so that soon we can all enjoy being debt free!

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Maximize The Power Of Micro-Payments

There was a time when I was infected with a terrible condition – Next Month Syndrome

When my credit card bill came in the mail, I would make a promise to myself -

Next month, I’m going to do better.

When I reached for my credit card to make ends meet, I would promise myself -

Next month, I’m going to do better.

When a friend would mention that he was living on a budget, I would promise myself -

Next month, I’m going to do better.

When I would read a story about someone saving for retirement, I would promise myself -

Next month, I’m going to do better.

Here are some common side effects of Next Month Syndrome -

A failure to regularly balance one’s checkbook

A propensity to run out of money before one runs out of month

A constant worry about higher and higher interest rates

A rolling credit card balance, which rarely goes down, but often goes up

A stack of bills, unorganized, or even, unopened, piled high on the kitchen counter

A box of abandoned budgeting software and personal finance books

A growing sense of worry and fear

If any of these symptoms sound familiar, fear not!  There are cures for Next Month Syndrome!

Gather up all of your most recent bank statements, your checkbook, and a calculator.  You need to find out exactly where you stand.

• How much money do you have in cash?
• How much money do you have in savings?
• How much money do you have in checking?
• How much debt do you have?

Create a budget.  It doesn’t have to be overly-complicated and you will struggle for the first month.  That’s okay.  The purpose?  You need to know exactly how much money you bring home and exactly how much money you spend.  Resources -

• Creating a zero-based budget
• Creating a budget if you have irregular income
• 10 things to do before you create your new budget

Develop some system for organizing financial documents.  For me, I use an expandable file box and I file bills alphabetically.  I use one file folder for each year’s bills.  At the end of each year, I simply store that year’s file box, and buy a new one.

• Set aside some time, monthly and weekly, to manage finances
• Encourage each member of the household to participate in the process

Consider reading the 33 Days Series here at No Credit Needed.  This information-rich resource should help those who are looking to save money and get out of debt.

If you are in debt, and you are ready to get out, consider the following resources -

• Debt Reduction 101 – A Beginner’s Guide To The Debt Reduction Process
• Debt Reduction E-Book – A free E-Book which will help you create your own debt reduction program

Now, I’ve saved the most important step for last.  See, when I had Next Month Syndrome, I was in denial.  I wanted to live just like everyone else and I wanted to own what everyone else owned.  Then, I discovered something, a deep dark secret – all of those people – the folks that I wanted to be “just like” – THEY had Next Month Syndrome, too!

I made a decision – the most important decision I’ve ever made.  I decided to do something about Next Month Syndrome.  I created a plan, I set myself with determination, and I turned away from my old lifestyle.  It took some time, and I still feel some of the long-term effects, but I was able to overcome Next Month Syndrome.  You can, too!

Remember – All of the planning in the world is useless, unless that planning is coupled with determination.  Make you plan – and then do all that you can to stick to it.  Don’t wait until Next Month – do something NOW!

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Next Month Syndrome

There are thousands of websites and hundreds of books about debt reduction and debt reduction techniques.  Personally, I’ve written several articles about my own debt reduction journey, a comprehensive guide covering how to get out of debt, and I’ve even created my own personal debt reduction method.

Today, I thought it might be beneficial to look beyond the methods and techniques, and really think about what keeps a debt reducer motivated.

What Works For Me – Debt Reduction Mindset

I like to keep things simple, so I like to focus on one debt at a time.  After listing my debts, and paying minimums to all creditors, I then spend my time trying to reduce the balance of the first account on my list.  As soon as I eliminate the first account, I’m pumped to move to the second account.  Focusing really helps.

I think it’s important to build community around a goal.  I like for my wife and I to be on the same team, and of one mind.  In fact, it would have been impossible for us to get out of debt, if my wife and I had not learned to communicate and work together.  We also surrounded ourselves with positive people and friends who would not cause us to stumble.

I find that I need to set an example of restraint and frugality.  It’s relatively easy to create a budget.  It’s a far more difficult thing to stick to a budget.  As a parent, I know that my kids are looking to me for advice, encouragement, and wisdom.  The sacrifices that I make today will pay big dividends in the future.

I have learned to eliminate the noise and listen to just a few, trusted voices.  Instead of trying fifteen different debt reduction techniques, or looking for a quick fix to my debt problem, I sat down, created a plan, and followed the plan.  I never pay attention to gimmicks and get-out-of-debt quick schemes.  Instead, I focus on paying the bills that I owe and following the plan that I have created.

I celebrate every success, big or small.  My wife and I have learned to celebrate our financial successes – without spending a lot of money.  We enjoy a date night or take the kids out for a day at the park.  I make a big deal out of our goals – and an even bigger deal when we achieve them.

I admit that I am human.  Here’s the reality.  Even though thousands of people visit my site each month (which blows my mind), I’m still prone to the occasional mistake.  When dealing with a setback, it’s important that I regroup, remember why I started the process in the first place, and move forward.  Even when I missed my original debt reduction goal date, I kept going.

What About You? -

I’d love to hear from you, my awesome readers.  What keeps you motivated?  What steps have you taken to keep your mind in the game?  Have you slacked off, but decided to get going as of today?  Leave comments here and / or connect with me via Twitter.

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What Works For Me – Debt Reduction Mindset

I love to watch football, especially my beloved Atlanta Falcons.  When I was a little kid, I played both running back and safety.  I really enjoyed being on offense, but I also learned the value of a good defense.  Throw in a little special teams unit, and you have yourself a complete team.

Thinking about debt reduction, I was reminded of the importance of the “team” concept.  I think it’s important to start with a solid defense, add in a powerful offense, and then compliment them both with some great special teams.  If we can find the proper balance between these three “units”, we can really dominate our debts – and soon be debt free.

Solid Defense -

Before I began repaying my debts, I established a small cash reserve – also known as an emergency fund – of about $2000.  Instead of relying on my credit cards for unplanned-for expenses, the small cash reserve provided a defensive cushion against life’s inevitable hiccups.  When I had to dip into my cash reserve, I would halt my aggressive debt repayments, rebuild the cash reserve, and then continue with my debt reduction plan.  Trying to reduce debt without an emergency fund is like playing football with only 7 men on defense.  You can do it, but it’s not very smart.

As I began to focus on reducing my debts, I always made sure to make minimum payments to all creditors – on time.  This helped me to avoid penalties (pun intended) like late fees and additional interest charges.  Even during the months when I could not make additional debt payments, I still made minimum payments.  One of the keys to debt reduction is to stop giving up ground (going deeper into debt) – and there’s nothing like making payments on time to reduce those dreaded fees and penalties.

I put my credit cards in my wallet – and then forgot that they were there.  Some will suggest cutting up credit cards or freezing them in a bowl of water.  For me, I wanted to learn a little discipline, so I simply put my cards in the wallet, and promised myself that I would not use them.  Four years later, this was one of the smartest decisions I’ve ever made.

Powerful Offense -

I created a debt reduction plan. I chose to make extra payments to the credit account with the lowest balance – others may choose to make extra payments to the account with the highest interest.  It doesn’t matter which plan you choose, but it does matter that you have a plan.  Some teams pass the ball, while others run.  Either style can win, but a team must be dedicated to its style of play.  The same is true about debt reduction.  Pick a strategy, stick with it, and stay focused.

I made multiple extra payments to a single account, each and every month.  Remember, as part of my defense, all minimum payments were made (on time or early).  After making those payments, I would spend the rest of the month feverishly working to make extra payments to the next account on my list.  A good offense is an intense offense.  This holds true for debt reduction, as well.  Honestly, if you are not a a little mad, and a little fed up, you might never get out of debt.  Making these multiple payments “kept my head in the game” and helped me maintain direction and focus.

Special Teams -

I made extra payments as early in the month as possible.  This reduced accrued interest, because it lowers the average daily balance.

I used unexpected income to boost my debt reduction payments.  I never considered using bonuses, gifts, or cash payments for anything other than debt reduction.  Remember, it’s important to maintain a laser-like focus.

I stopped waiting for the hail-Mary, and began to focus on the routine (and boring).  Instead of waiting for the next raise, or the next paycheck, or the next whatever, I decided to take the income that I was already making, and deal with my situation.  If I had continued to wait for things to “get better” – I’d still be in debt – and I’d still be waiting.

I decided that it was okay to be different.  Quick story – The other day I went to buy my wife a gift at a department store.  The customer service representative who sold me the gift asked me if I wanted to apply for a store-branded credit card.  I declined, even though the store was offering a 15% discount for signing up for the card.  The woman behind me in line could not believe that I would give up the “free money”.  I politely explained that my wife and I pay cash for the things we want.  The woman behind me said, “Yeah, that might work for your wife’s clothes, but I’ll bet you borrow money for things you want, like a new truck or a boat.”  (It felt a little odd to be having this conversation with a complete stranger.)  I said, again politely, “No, mam.  I pay cash for everything, including our last new automobile.”  She said, “Really?  Why?”  (At this point, I was almost tempted to give her the address for this site, but I refrained.)  I simply replied, “For 15 years, I lived paycheck to paycheck, and I borrowed money.  Now, I’m debt free, I pay cash, and I’m happier than I’ve ever been.  This is what works for us, and as long as it’s not broke, I’m not going to try to fix it.”  She then looked on, a bit stunned, as I pulled out my cash envelope, paid cash for a really nice gift for my wife, placed my receipt in the envelope, and headed on my way.  It’s fun to be different!

I want to thank those of you who have subscribed to No Credit Needed.  I’m back home from vacation and my family and I had a wonderful time.  Also, I noticed that several of you have followed me on Twitter.  Thank you so much, and feel free to drop me a tweet.  Regular posting will resume as of today!

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Debt Reduction Game Plan

I have some awesome news that I want to share with you  guys.

My parents are debt free!

I just got off the phone with my Dad, and he was so excited.  For more than two years, my Dad has been focused on paying off his mortgage.  Month after month, he made his regular payments, and then used every, extra available dollar to reduce his principal.  Today, he was able to walk into his credit union, hand them a check, and pay off his mortgage!

I cannot explain to you how happy I am for my Mom and my Dad.  I asked Dad for permission to write a bit about their story, and he was happy to share with you guys.  Basically, after reading some of the articles here at No Credit Needed, Dad decided to get out of debt and pay off his mortgage.  After just a few months, he was able to rid himself of his consumer debt, and then he began to focus on ridding himself of a mortgage payment.  Through hard work, sacrifice, and determination, he paid off a 15 year note in less than 7 years, with the majority of the payments coming in the past 2 years!  How cool is that?!?

I love it when I hear about people who are debt free, even people that I don’t know.  Can you imagine how cool it is for me to hear that my parents are debt free?  I’m very close to my Mom and my Dad and I can’t wait to see what their debt free future holds for them.

For those thinking about debt reduction, consider reading – Debt Reduction 101 – and begin your journey towards being debt free.

Mom and Dad – you rock!

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Great News – My Parents Are Debt Free!

From a recent email from “Rick” -

If you had to begin your debt reduction journey today, would you immediately begin to attack your debts or would you first take the time to build up my cash reserves?

This is a great question, and one I’ve been asked several times.  First, for the sake of this article, I’ll refer to my cash reserves as my emergency fund.  Second, I’ll simply share my thoughts on the subject, and leave the financial advice to a qualified professional.

If I Were In Debt Today…

1. I would create and begin to use a zero-based budget to manage our household finances.
2. I would list each of my creditors and develop a debt reduction strategy.
3. Before making any extra payments to my creditors, I would fund a small emergency fund, equal to $500 per person in our home.  For our family, that would be $2500.  (Four years ago, our youngest daughter had yet to be born, so our figure then was $2000.)

Just two weeks after we began our debt reduction journey, our son was hospitalized.  It was during this time that my wife and I learned the value of the emergency fund.  While insurance covered the cost of the hospitalization, there were a few associated expenses for which we were directly responsible.  These were, obviously, unexpected expenses, so we used money from our emergency fund to pay for them.  If we had not funded this small emergency fund, we would have been forced to use our credit cards, thus digging ourselves deeper into debt.

Please note, while we did stop making extra payments to our creditors, we continued to make minimum payments.  It is crucial to make all minimum payments, in full, and on time, throughout the debt reduction process.  If you are late with payments or you pay less than your minimums, you will be paying late fees and added interest.  We hate fees.

There are several ways to calculate how much money one should have in an emergency fund, especially the beginning, smaller emergency fund.  I arrived at the $500 per person amount by adding our automobile insurance per accident deductible to our family-wide health insurance deductible.  I figured, optimistically or pessimistically, depending on your perspective, that we would have one health-related crisis and one automobile-related crisis during our debt reduction journey.  In the end, we had two health-related inconveniences (neither really reached the level of a crisis) and nothing really went wrong with out automobiles.  For our family, I calculated that a single crisis, whether it be health-related or automobile-related, would cost roughly $2000, so that’s the amount with which I went.

Throughout our debt reduction process, our small emergency fund balance fluctuated between $1000 and $2000.  We had to tap into it on three different occasions, and while this slowed our debt reduction progress, just a bit, we also managed to avoid using our credit cards.

If I Had Just Paid Off My Debt Today…

1. I would celebrate!
2. I would continue to live on a budget.
3. I would redirect the money which had been going towards debt reduction and use it to build my permanent emergency fund.

As soon as I made my last debt reduction payment, I began to build my permanent emergency fund.  To the $2000 already in the small emergency fund, I quickly added an additional $18,000.  For my family, $20,000 represents roughly six months’ worth of expenses.  This money is untouchable, and is to be used only in the case of extreme, actual, real, I-cannot-believe-this-is-happening, emergencies.

If you just spend some time in the archives, you will see that I refer to my emergency fund by another name: non-retirement savings.  I do this, simply to differentiate this money from any money that is held inside a retirement account.  Not to split hairs, but there is a slight difference between non-retirement savings and the emergency fund, in that the former can be used for any expense (budgeted or non-budgeted) and the latter is to be used specifically for emergencies.

Again, the $20,000 amount is specific to my family and our current situation.  For some families, this number might be $10,000.  For others, it might be $50,000.  In fact, I actually have a poll open, asking readers the question – How Much Is 6 Months Worth Of Expenses? If you haven’t done so, click over and vote.  As of today, more than 1100 votes have been cast, and the most popular amount is somewhere between $12,000 and $20,000.

To summarize -

Before and during debt reduction, I would maintain a small emergency fund, based on the size of my family.

After debt reduction, I would increase my emergency fund to six (or more) months’ worth of expenses, again tailored to my family size.

The debt that I am referring to in this article is non-mortgage debt.

Finally, if I had children with special needs or a family member with certain fixed medical expenses, I would consider a larger emergency fund, both during and after debt reduction.

These are my thoughts.  What would you say to “Rick” about debt reduction and the emergency fund?

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Debt Reduction And The Emergency Fund