Paying off your debt

Posted by PhroBoy - Financial Wonderboy | Site News | Wednesday 10 November 2010 9:01 pm

This post will primarily help those trying to pay off credit card debt.  

Credit cards can be wonderful things – to the right person! Some cards offer points and rewards just for using the card. However, if you do not pay off the entire statement balance before it is due, you will pay interest and give up potentially any benefit you gained. My tip for credit cards is to use it like cash. If you don’t have the cash to pay off your credit card right away, just put your credit card back in your pocket.

If you have credit card debt, the first thing you need to do is to get rid of your credit cards – stop charging! You have to stop in order to get better. Create a budget and set how much money you will set aside each month to pay it off. Be ready to struggle because you have already lived easier than you should have when you got yourself into the credit card debt in the first place. If you only pay the minimum balance, you will never pay the card off and the interest will keep accumulating.  Track every dollar your spend, and you’ll be amazed at where you’ll be able to save.  Here’s the priority list: pay God first (>10% – be charitable!), pay yourself second (20% is preferred – savings and paying off debt money), and the rest can be used for all else.  Follow this order and you’ll be amazed at the freedom you’ll have!

Now that you have stopped charging against your credit and set a budget, you are ready to pay your debt down in the most efficient manner possible. The key is to pay off your highest interest rate first. Look at all (credit card, auto, student loans, etc.) debts and organize them from highest rate to lowest rate. Now that you have all of your debts with the interest rates lined up, put in the minimum payment that is required for each debt. This is now your base so you know how much you have to pay off each month.

You have budgeted how much you are going to sacrifice each month to paying off your debts, so you take the amount left after all the minimum payments and use it to pay off the highest interest rate first. The more you can set aside, the quicker you can pay off your debts. Once you have paid a card, don’t make the mistake of charging more on it. Avoid your highest interest rates like the plague. My friend Patrick likes to say he is like a Gazelle to get out of debt. Be a Gazelle – get out of debt!

If you’re really serious about getting out of debt, here is a site set up by my personal finance professor from college to help people manage their finances. Here is a file to help you set up your budget and line up your debts for you in priority of how you should pay it off. I’ll deal with setting up budgets in another post.

Remember, if you’re in debt, you have to change your behavior. You’re a slave to a creditor. Whether you could avoid it or not, you have to change the way you live to make the situation better. Don’t buy a new car when you can buy a perfectly good used one. Don’t go out for lunch when you can just as easily make yourself a sandwich. Don’t use more of your credit when you’ve already abused what you’ve been given.

My wife and I would like a mini-van or perhaps an SUV because it would be easier to get our kid in and out of the car and to take trips. We have been living off of one car through car-pooling and public transportation since we have been married. We might be getting a new car, but the only car we can afford to pay cash for is one that costs $1,500 and works just fine. Taking a lunch to work everyday gets really old, but we do these things because we know in the future we can start to live without the burden of debts and with the satisfaction of knowing we are living within our means.  It may sound like life sucks, but avoiding debt is freedom and happiness.

Debt – the Basics

Posted by PhroBoy - Financial Wonderboy | Site News | Tuesday 19 October 2010 11:45 am

I believe my last post was a little technical.  However, come tax season, when you actually care about saving money on taxes, I suggest reviewing it in detail.  It could save you a lot of money.

When asking what people wanted to learn more about with regards to finances, a majority of the responses were from people who wanted to know how to avoid or get out of debt.  I thought it might be good then to start with the basics.  Debt – it’s like free money…except that it’s not free and the burden will never go away until you pay it off. This is how most retail financial institutions (e.g., banks) make money. They say “Sure! You can have $10,000 to help with your tuition, and you don’t have to pay me back until 6 months after you graduate.”

Example of $10,000 student loan

Let’s say you’re able to get a great student loan rate of 5% (credit cards can have annual rates over 20%) and your payment plan is over 10 years.  Unless this is a government student loan, you are accruing interest while you still go to school even though you are not paying anything yet.  For ease of my example, let’s assume that at the end of school, when your payments kick in, you have accrued $2,500 in interest (for you finance geeks this is a rough estimate of $10,000 accruing compounding interest over 4 years @ 5%).  That means you end school having to pay off $12,500 even though you only got $10,000 in cash for help with school.

The lending company (i.e., the bank) will set out a payment plan for you to make equal payments over the ten years you have to pay it off.  In our scenario, it roughly calculates to $130 a month.  If you multiply that times the number of payments you will be making (120) you will have paid the bank back $15,600.  Though you only got $10,000 in cash initially, you will have paid the bank over $5,000 in interest plus the original $10,000.  That stinks!  If your payment plan is over 20 or 30 years, you will pay even more in interest.  If your interest rate is higher like in the case of a credit card, you could be paying far more in interest alone than you ever received in cash.

Conclusion

That, my friends, is why the banks make so much money and why you should avoid going into debt! That’s the basics – STAY OUT OF DEBT!!!

If you can’t avoid it —

  1. Get as little of it as possible. Live like it’s not your money and you are dirt poor…because you are dirt poor when you’re in debt!  Don’t buy a new car, don’t go out to eat, don’t lose track of your budget!  If you are in debt, you should live like you are a slave to it so you will have more money to buy back your freedom sooner.
  2. Pay it off as early as you can.  Keep living like you are dirt poor even when you have a salary that indicates otherwise.  Anything you pay above the required monthly payment can pay off the balance of the debt and reduces the total interest you pay. The bank gets far less of your money that way.  (Note – some lenders require you to indicate payments specifically as “principal repayment” otherwise they will consider it as next month’s payment paid early; check your loan agreement)

To quote Dave Ramsey, “If you will live like no one else, later you can live like no one else.”  Great words to live by!
Getting into debt is easy, but getting out will be tough.  Good luck!

The next post will be on a plan to pay off your debts in the most efficient manner possible.

Tax Credit vs. Deduction

Posted by PhroBoy - Financial Wonderboy | Finance | Saturday 12 June 2010 8:08 am

The not so mighty, but still Afro and Whitey younger brother, PhroBoy provides everyday tips regarding how to manage your wallet – most relevant to those making less than $100,000 in total household income.  He has recently started working as a tax consultant for a large public accounting firm and being poor, young and married has some practical advice regarding your finances.

I do not profess to be a tax expert, but I realize that I understand more than most. I warn you that with my background in tax and accounting, I have a tendency to be too technical. If you ever find that is the case or you do not understand something, please post a comment, and I will try and respond with a simpler explanation.   My goal is to save you money!

I’m pretty sure the following language is necessary with anything I post about:

This information is not intended or written to be used, and it cannot be used, for the purpose of avoiding U.S. federal, state or local tax penalties.

With this post, you can follow along and learn by referring to the U.S. Individual Income Tax Return Form 1040.

What is a tax credit vs. a tax deduction?

  • Tax Deduction

A tax deduction is something that reduces your taxable income, the base on which the tax you owe is calculated.

In tax, you break up deductions between “above the line” items and “below the line” items with the line referring to your Adjusted Gross Income (AGI), the last line on page 1 or first line on page 2.

Your AGI is important for several reasons, and generally, you want it to be as low as possible. Your AGI is used to determine limitations on other deductions (i.e. – if you itemize, medical expenses are reduced by 7.5% of your AGI). Your AGI can be the starting point for your state tax return as well, so above the line items may reduce your state taxes where below the line items may not.  If you look at the 1040, everything on page 1 is an above the line item. Contributions to a Health Savings Account (HSA, subject of future post), moving expenses, educator expenses, student loan interest, contributions to a qualified traditional Investment Retirement Account (IRA, also subject of future post), etc.

Below the line items include the items on page 2. This would be your standard deduction or itemized deduction (you take the larger deduction of the two), personal exemptions (for those you can claim as dependents, including yourself), and special items for the elderly or disabled.

Notice that on line 43 you arrive at and calculate your taxable income, different from AGI, and on line 44 you calculate the total amount of tax you owe (your tax liability) using graduated tax rates. Notice, no credits have come into consideration.

  • Tax Credit

A tax credit is a special gift from the government. Both these and many deductions vary by tax policy. Credits are very politically driven and can change quite often.

Remember that you have calculated the amount of tax due on your taxable income before considering any tax credits. Credits are like deductions of the tax you owe as opposed to deductions which reduce your taxable income.

Let’s say you have $50,000 of income. Both your above the line deductions and below the line deductions reduce your taxable income by $20,000 leaving you with $30,000 of taxable income. The tax you owe (your tax liability) is a percentage of your taxable income according to graduated rates (you can use the tax income tables provided in the 1040 instructions to make it easier). For the sake of the example, assume you had a 10% tax rate on that income resulting in a tax liability, amount you owe, of $3,000.

Any credits you qualify for can reduce that $3,000 tax liability to zero even if your credit is greater than your tax liability unless it’s a refundable credit.

  • Refundable Tax Credits

Refundable credits are fantastic, especially if you can manage to reduce your tax liability to zero.  After your tax liability is reduced to zero, you get a refund for the remaining amount of the credit.

Using the previous example, let’s assume you qualify for a $3,500 Lifetime Learning credit which is a non-refundable credit. Since this is not refundable, your credit is limited to your tax liability or $3,000. You do not get any benefit from the extra $500 you qualified for.

Continuing the scenario, let’s assume you also qualify for the Making Work Pay refundable credit for $800. Now your tax liability has already been reduced to zero by the Lifetime Learning Credit, but the Making Work Pay credit is refundable meaning the government will send you a check for $800.

Thanks to refundable credits, my family received over $12,000 as a tax refund this year without paying or withholding a single dollar from my paychecks. The entire check came from refundable credits (2009 had lots of them).  Granted, I only received that money because I do not make very much money, but through proper planning, you can make sure you take full advantage of the deductions and credits available to you.

Takeaways & Strategy

Depending on your situation, you may pick and choose whether you elect for a deduction or a credit.  For example, my wife and I had education expenses this last year.  There are 3 options we qualified for with these education expenses: lifetime learning credit, a $4,000 above the line deduction, or American Opportunity refundable credit (the expanded Hope credit for 2009, previously non-refundable).  I only qualified for the first two while she qualified for all of them.  However, you can only choose one for each person with qualified education expenses.

First, I checked to see if the $4,000 deduction (the limit per return, not person) would leave me with a $0 tax liability after applying everything except my refundable credits.  This would have been ideal because the lower AGI would have helped me to reduce my state tax liability since my state starts its tax calculation with my AGI.  However, this was not enough to bring my tax liability to $0.  I decided to use the lifetime learning credit because that completely eliminated my tax liability where the $4,000 deduction couldn’t  .

Second, after reducing my tax liability to $0, I was free to take all the refundable credits possible and receive a refund of all the money that was withheld from my paychecks.  We took the American Opportunity credit for my wife’s expenses, and we received the entire refundable amount of $1,000.

It is important to understand the deductions and credits available and how they affect your tax return as there is some strategy to be made.  You can’t be sure that any software or tax return preparer will catch the strategies available to you.  The software I used did not, and because I caught it, I saved over $500.  Take a look at your return and play with the numbers.  If you realize that you could get more money back, you can always amend your return and claim the money you are due.

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