Friday, October 20, 2017

Personal Finance Battle Plan: Ms. DebtFree

Mr. DebtFree here, in this post I will be laying down the framework for how we are approaching Ms. DebtFree's financial situation.  This is a real life case study of Ms. DebtFree and how we are setting her up for financial success.

Case Study:

Name: Ms. DebtFree
Age: 26
Status:  Graduated Nursing School August 2017 and begins full time work as an RN.
Starting Salary: between $50,000 and $60,000 per year (dependent on shift work and overtime)
Starting Debt: $94,688 with interest rates ranging from 3.4% to 7.9%
Starting Cash: ~$200
Starting Invested: $130
Average Monthly Spending: ~$1,600 (does not include loan payments)
Average Free Cash Flow:  $1,700 (Income - Spending)

Phase One:  Build up your stash, the Emergency Fund.

The very first step is to make sure Ms. DebtFree has money saved up for a rainy day.  Normally an Emergency Fund should include 3-6 months worth of spending saved if you have a steady predictable income source.  If income is more sporadic 6-12 months will better protect you should any unexpected expenses arise.  Examples of these expenses include medical emergencies, unexpected car or home repairs,  unexpected travel, etc.  

Our Strategy:  Because Ms. DebtFree lives with a partner who can help offset sudden expenses we will keep her Emergency Fund on the low side and save up $5000 which is slightly more than three months spending.

Phase Two:  Free Money?!?  Meet your employers 401k match

Ms. DebtFree's employer offers a 5% 401k match.  Taking full advantage of your employers retirement account match is probably the best return on your investment you can get.  If your employer does not offer this benefit skip this step for now and move on to Phase Three.  

Our Strategy:  Ms. DebtFree is putting just enough into her 401k to meet her employer match.

Phase Three: Relentlessly Crush Debt.

There are many strategies for approaching debt: 

The first strategy involves paying off debt by wiping out the loans with the lowest balance first, working your way from bottom to top.  This method gives you a psychological boost each and every time you eliminate a loan and allows you to apply the extra money that would have gone to the now nonexistent loan to the next lowest balance loan.  Think of this like a snowball gaining more and more momentum as it speeds down a mountain. 

The second strategy involves attacking loans in order of highest interest to lowest interest.  In the long run this method will save you the most money and is financially the most efficient way to attack debt.  

Our Strategy:  Ms. DebtFree has a large variety of loans ranging from lower (3.4% interest) to higher (7.8% interest).  We will be tackling this debt by using a hybrid strategy.  Two of her smaller loans sit at 6.8% interest, we will be diverting all extra money to these two loans using the snowball method until they are fully paid off.  This will give her that early psychological victory while killing two of her higher interest loans.  We will then employ strategy #2 to go after all remaining loans starting with the highest interest and working our way down.  

Phase Four: Take advantage of the tax advantage.  401ks IRAs etc.

The next step for Ms. DebtFree is to save for retirement and pay less now in taxes.  

Our Strategy: Ms. DebtFree happens to have a great 401k plan through work that allows her to take advantage of low cost Vanguard Index Funds.  For this step I will have her max out her 401k ($18,000 per year as of 2017 and 18,500 in 2018).  As well as max out a traditional IRA ($5,500) per year as of 2017.  I am a huge believer in keeping as much of the money that you earn as possible.  

Phase Five: Invest like a boss.

Our Strategy:  With the tax advantaged accounts maxed out and all of the debt paid off, we will be putting any additional money into taxable vanguard accounts.  This money can be used as an additional Emergency Fund, a down payment on a house, early retirement, etc.  Once Phase Five is in effect, safe and secure retirement is inevitable as long as monthly spending does not trend upwards.  

Current Status:

We are two months into Ms. DebtFree's working career.  As of this month, the Emergency Fund will be topped off, she is meeting the employer match for Phase Two, and although the Debts from Phase Three are still in deferment for the next few months, we will preemptively attack them by launching into the Phase Three Strategy in November. 

Adding up all of the loans and interest rates that Ms. DebtFree is responsible for we come to a total loan of $94688 with a weighted interest rate of 6.3%  Using her spare $1,700 per month towards loans she has a payoff period of ~67 months.  During which time she will have paid $17613 of interest to the banks.  So in under 6 years with no increase in monthly spending or decrease in income Ms. DebtFree will truly be debt free!

One last piece to consider.  Ms. DebtFree's college loans total $35049 with an average 4.45% interest rate.  Her Parent Plus loans however total $59638 at a whopping average 7.39% interest.  It looks like it is time to look into re-financing options to see what we can do with those parent plus loans to get them down to a more reasonable interest rate.  A topic for a future post!

Thank you for reading and good luck to you in your own debt situation.

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