1) Buying a Car & Consolidating Debt
The primary driver for Sara seeking advice is the need to figure out a plan for paying off debt, while anticipating taking on an additional car loan on an already stretched budget.
Sara isn’t extravagant with her automobiles. She believes cars are simply transportation and has had her current car for more than 10 years. As repair bills are mounting, she will need to replace her current car soon with another gently used vehicle. She may receive up to $1,000 in trade-in value on her current car, and will need to finance the purchase.
She has been approved for a $9,000 loan at 3.75 percent through her credit union, which would add another $164 per month to her budget for five years.
One area of worry for Sara is the balances she carries on store brand credit cards. These cards all have interest rates exceeding 20 percent. The total balance of these loans is about $4,000. In addition, there is a current 401(k) loan of $2,100 and a balance of $3,775 due on tuition under a deferred payment plan with the university she received her master’s degree from. Since this was a deferred payment plan put in place by the school rather than more traditional loans, she has no choice other than to discuss an alternative payment plan with the school. Thus, Sara would prefer to tackle this debt with a plan to consolidate all debt.
The budget is tight, and Sara is now faced with the repayment of school tuition of $157.25 per month, which will begin immediately. With this new expense, the total cost of the debt repayments is roughly $325 per month.
Consolidated Debt Plan
We recommended that Sara consolidate her debt due to the relatively high payments and interest rates, and the fact that a car is a necessity.
The end result of our plan will be:
A new car loan, which Sara’s local credit union has already approved.
Refinancing the remaining debt of about $10,000 (50 percent of her current account balance) with a 401(k) loan at a fixed three percent rate.
Under most circumstances, it is not preferred to consolidate debt with a loan against a 401(k) account. While 401(k) loans are not preferred, there are a few factors that make this the recommended option.
This is an emergency need in order for Sara to maintain her lifestyle. The monthly budget is tight and the extra car payment may not be possible at a higher rate.
The fixed interest rate makes this a better choice than a 12 percent variable personal loan, or the variable rates on the credit cards.
The risk with this method is that if Sara loses her job, or finds another, she will have only 90 days to find a way to pay back this loan, or she will have to pay income taxes on the distribution, and a 10 percent early withdrawal penalty since she is under age 59 1/2.
Sara is cost conscious and not likely to continue to run up additional debt, which is critical if consolidating debt against an asset like a 401(k). She is also confident her job is not at risk, and is not worried about the possibility of having to repay the loan. To Sara, the extra breathing room over paying the high interest rate on the credit cards is worth the additional risk that comes with securing debt against her assets.
The ending scenario will be a debt payment plan of 60 months with combined payments of $344, including the car loan. This is only slightly more than the $325 previously paid without the car loan. The plan is to maintain the loans, while not taking on new debt. Any additional income from wage increases will be applied first to an emergency fund to backstop future emergency needs as outlined below in the budget and saving plan.
2) Budget & Savings Plan
Since cash is always stretched, Sara’s primary goal is to gain comfort with her savings and spending plan. However, she does not know what amount should be contributed to savings.
She knows that she needs a better handle on where everything goes in a month, but she doesn’t think anything is being wasted. Sara should continue to review her budget on regular intervals for prospective items to cut.
One area in particular that many people can review is their cable/internet/phone provider costs. Sometimes simply calling your provider will lead to options for discounts of six months to one year. In addition, online phone and television alternatives (like Skype, Google Voice/TV, or Hulu) can dramatically cut the costs of entertainment and communications.
Since Sara does not want to find herself back in this same spot after paying down the loans, the reworking of the debt and car loan is integrated with the savings goal.
Savings Plan: Savings Account for Goals
We recommended that any extra monthly cash, as well as increases in salary or other income, go toward building an emergency fund of at least six months of expenses prior to paying any additional amounts on debt. This may not seem intuitive, but by being able to pay for future items with cash, Sara should feel some comfort that eventually she can be debt free. An additional benefit to paying with cash is that spending will become more conscious. We want to get to a point where cash ‘shocks’ in the future, such as needs for a car, will be able to be drawn on from the saved cash reserves.
Sara has investigated savings accounts at her local credit union and will check her options there, as well as at online banks which may offer a higher interest rate.
The hardest part about getting a savings plan in place is getting started! It is easy to over think questions such as how much and where should you save. It often helps to ‘start small’ at a bank you are already comfortable with to get the ball rolling on a savings habit. The amount can be modified later once you have a better handle on how much additional cash you have each month.