I recently attended a meetup with a group of people in serious debt. There was a discussion of what to do and some interesting ideas were brought out. The following ideas probably applies to those who are in a serious cash crunch.

If your present income has taken a hit and you are very stretched, you may have to take some of the following steps to relief your debt payment burden.

1. Get a second job - You will definitely get more income. You have to weight that against the time you have for your family. This is probably the least drastic measure you have to take.

2. Eliminate or reduce your 401k contributions - You can reduce your 401k contributions temporarily until your situation improves. Once your cash flow situation improves, you can resume normal contributions.

3. Negotiate with the IRS - If you really have difficulty with your payments, you can negotiate a payment plan with the IRS. You probably have to get a tax professional for this.

4. Downgrade to a smaller house - If push comes to shove, you can sell your home and move to a cheaper home. This may take a while (given today’s market condition), but should be explored.

5. Selling any high priced possesions - Think second homes, boats or even anything that is simply taking up space in your garage or closet.

These were the few ideas that were tossed back and forth. Please feel free to comment on any other thoughts you have.

When you are having a tough time reducing your debt or are in sort of a cash flow crunch, one of the things you should do is to prioritize the bills you pay. I have listed various bills below according to how important they are.

Must Pay Bills

1. Mortgage or Rent (HELOC) - If you do not pay your mortgage, you risk foreclosure. If you do not pay your rent, you risk eviction. If you cannot afford your mortgage, consider selling your house and move to a less expensive house.

2. Medical Insurance - You risk incurring a disastrous medical bill if you do not have insurance. You have to pay this bill. There are ways to save on medical bills. Examples iinclude having higher deductibles, HSA accounts etc.

3. Child Support - You can end up in jail for not paying your child support.

4. Income Tax - Better pay this one. You risk wage garnishment and potential loss of any tax refund by the IRS.

5. Court Judgement - You risk wage garnishment.

6. Student Loans - The consequences are the same as not paying income tax - wage garnishment and loss of tax refund. By the way, student loans are almost never wiped out even if you file for bankruptcy.

7. Secured Loans (especially on property - like HELOC) - You risk losing your property to repossession. For business owners, it is the same as a loan that is backed by your equipment.

Bills that will hurt your credit score but are not disastrous if you do not pay

1. Credit Card Bills - Well, your score takes a hit, but you will never lose your house or go to court! In fact, if it is your first time with a late payment and you call the company, you may not even have that reported to the credit bureaus.

2. Medical Bills - You might get collection agencies hounding you, but you will certainly not end up in the streets.

3. Legal Bills - Same as medical bills.

Personal Loans - Ditto. Credit score takes a hit. Your banker friend will not be your friend anymore.

Loans from your friends, family members, relatives etc - Well, they are hopefully the most understanding of the lot.

A couple of post ago, I mentioned that I met Mr X at a party and he started talking to me about how he got out of debt because he found out that I had a credit card review site.

One of the things that Mr X did quickly reduce his debt was to sell any unnecessary junk that he had lying around the house. Mr X told me that he was quite a compulsive shopper and bought many unnecessary things and gadgets! But he first had to develop the habit of not spending money impulsively. Then he told me his story of how he got rid of his junk and clutter in his house.

All his electronic gadgets (like cell phones) which he got sick off was sold on ebay. His next big ticket item was his car. Yes his car. He sold his car and bought one that was 12 years old and had 150,000 miles on it. He chose a Toyota Corolla (which he figured was give him less problems and claims that till this day, it has not). He even sold his Rear Projection DLP TV set which he bought on credit and lived for a couple of years without TV (no cable bills either). He managed to raise a few thousand dollars through clearing his whole house of stuff that he did not want or need (including an extra refrigerator that he got free from his old rented house!),

While he still had debt even after this asset sales, it did reduce his debt load and his monthly payments. But more importantly (according to Mr X), it made him realize that he did not need a lot of the stuff that he always buys on impluse. So his advice is that if you have credit card debt, look around your house and see if you could sell anything that you really do not need or have bought on impulse. This may be the quickest way to cut down your debt load.

I recently met a new friend, Tom, through an introduction at a party. Tom is a graduated from college 4 years ago and when I told him I have a credit card review site and personal finance blog, he started talking to me about his student loans that he has to repay and the credit card debt that he has got into during his college years.

Tom told me that when he graduated, he was saddled with about $40,000 in student loans and credit card debt. It was up to his eyeballs and he just did not know how to reduce them in the beginning. But four years later, he had cut his debt by half and it now stands at about $20,000.

Tom said that one of the most important things he did was to actually breakup his debt reduction goals into biweekly and monthly goals. He felt that if he was staring and thinking about the whole amount, he would simply get discouraged and lose his spending discipline. So what he did was to break them down into monthly goals.

To arrive at his monthly goal, Tom set out a detailed budget based on his monthly salary. He made a point not to accumulate any more credit card debt or any other debt for that matter. He had to make some sacrifices. At certain points during the last four years, he had to take a second job and moved in with his parents for a short period. But his goal was to reduce his debt by $500 a month.

It has not been a comfortable ride. Instead, there are lots of sacrifices. Unrepaired stuff in the apartment, driving around a really beat up third hand car are just some of the sacrifices he is making. But Tom does not want to take another four years to get rid of his debt. Hence, he is planning paying off his debt faster.

Tom says that by just focusing on monthly debt reductions, he is essentially taking a big burden and breaking them into “smaller burdens”. By consistently meeting his monthly target, it motivates Tom even more and reinforces his determination to reduce his debt even faster. Tom also does not feel as burdened as before because he knows that if he can just repeat what he is doing every month, he will be out of debt before he knows it. Paying off his debt is as Tom says a “monthly routine”.

When you have credit card debt which you are trying to pay off, everybody will tell you to set up a debt reduction plan and budget and stick to your plan. But when you look at your budget, how do you decide which items to reduce? Here is how I would look at it.

I would first seperate your budget and expenses into 3 groups.

Necessary Expenses

The first group is what I’ll call the necessary expenses. Your mortgage, auto loans, credit card debt, essential utilities, education expenses, groceries, gasoline fall under this category.

Expendable Expenses

The second category of expenses is what I would call expendable expenses. These are expenses you can actually do without. They include cable tv, netflix, gym memberships, club membership etc. These expenses tend to be recurring. These items in the past would have been considered luxuries, but are now considered essential!

Self Improvement Expenses

These expenses include spending on books, seminars, networking events that will help your career.

3 Ways to Deal with Each Type of Expense

There are three different strategies to deal with each type of expenses. For the neccessary expenses, you cannot do without them. But there are ways to reduce these expenses. You can refinance your mortgage, save on your groceries and utilities etc.

It is in the “expendable expenses” where you can actually save the most. Or at least sacrifice them temporarily until your finances improve. Stop going to the gym and work out at home or run outdoors. If you really wanted to, getting rid of your cable tv may lead to a more productive life. Netflix forces you to watch lots of movies where time can be spent at perhaps “money generating activities”.

While, it is tempting to trim all the fat, make sure you do not cut any muscle off! Activities like business networking and self-improvement may help you in your business or career and if anything, you should invest more in yourself.

Conclusion

When I graduated and just started work, I had very few “expendable expenses”. It was only after I had a few salary raises did I start adding some of these expenses. I did not have cable tv for a couple of years. I also stopped paying for my gym membership when I realized that me paying a monthly fee did not force me to work out regularly!. For what it’s worth, looking at my budget this way early in my working life has helped me trememdously in my finances.

How big a mortgage can you take? How much credit card debt can you carry?

Much has been made about good debt versus bad debt. Getting a mortage for your home is “good” while an “auto loan” is bad because your auto purchase will depreciate. But how much debt can you afford. Below are some guidelines that in my opinion, you should consider.

Stability of income

How stable is your income? This is a very important factor. The more stable your income, the higher debt load you can sustain. Doctors, for example, can afford to have a bigger mortgage than most of us. It is not just because they have high income, but also because they have higher income potential that is more stable. Most new doctors who graduate have a ton of student loans. Yet banks are slightly more lenient on them simply because they have high and yet stable income growth ahead of them. Many doctors have high student loan debt, a mortage and very little cash and investible assets in the beginning of their careers.

However, if you are an insurance agent or real estate agent, then your income inherently is less stable (though lucrative). Your ideal debt ratio will depend on your income and assets.

Alternative source of income

Do you have alternative sources of income? Do you have a rental property producing postive cash flow? How much dividends are your investible assets giving you? The more sources of cash inflow you have, the better your ability to take on debt.

What is Your Coverage Ratio?

When bond investors invest in bonds, one of the key ratios they look at is the companys’ coverage ratio. What is the the cash flow versus interest payments? For triple A bonds, it is not uncommon to find coverege ratios of 10. For junk bonds, coverage ratios of 1.2 to 1.5 are not uncommon.

What is your coverage ratio? How much income are you bringing in? What is your interest payment every month. To be even more conservative, subtract all necessary household expenses from your income and use that number to calculate your coverage ratio. Ask yourself what your coverage ratio will be if you take on a loan, credit card debt, or a mortgage? If you coverage ratio will barely be one, then you should reconsider whether or not to take than loan or mortgage. If your coverage ratio is above 3 and you have a stable income, then you will be a lot safer.

What is your Debt to Equity or Asset Ratio?

How much debt you can take is also influenced by what is your net worth. If you have a few properties free and clear, taking on another mortgage may not be an issue even if your income source is not stable. Before you take on another debt, be sure to calculate your net worth, both equity and assets, accurately.

How much cash on hand do you have?

Ford and General Motors are in big trouble for their North American Operations. But has kept them going is that they have tons of cash on their balance sheet.

How large is your emergency fund? How long can you last if your present source dries up? Think long and hard about this when before you take on any new debt.

Summary

To sum up, I think you have to look at a variety of factors before you can decide how much debt you can take - whether it is a mortgage, auto loan or home improvement loan. Look through these factors carefully before making any big decision that will impact your financial future.

A couple of days ago, Tricia from Blogging Away Debt wrote about her dilemma as to whether to participate in a 401K plan or to reduce your debt. Another common dilemma is whether to use your money in the savings account earning 5% to pay off your credit card debt which you are paying 18%!

I’d thought I’d add write about my opinion about this subject matter. Truth of the matter is that there is no set rule as to what you should do. Doing the math is not the only thing you have to look at. But rather, I think one should consider his or her own situation. This is how I would look at it.

1. Do you have an emergency fund?

Having a three to six months (maybe more) worth of emergency money in your money market account or simply in your savings account is a smart thing to do because anything can happen. Layoffs, company go bust can happen any time. If you do not have an emergency fund, then you should be saving up for that rather than using what you have to pay down a chunk of your debt.

2. How stable is your job?

If you work in the the public sector and have job stability, then perhaps you do not need to have six months worth of rainy day savings. Perhaps you can make use of some of that emergency fund for debt reduction, or you can comfortably go ahead and enroll in your company’s 401K plan (assuming you have a solid debt reduction plan).

3. Do you have disability insurance?

Does your company provide you with disability insurance? Do you have one. If you do not have one, then you certainly need more emergency money.

4. Are you living on two incomes?

If your spouse loses his or her job, you do have sufficient income to cover your household expenses? If not, then perhaps adding to your emergency fund rather than paying off a big chunk of your credit card debt may be the better solution.

Ask yourself what happens if…..

If you are still not sure, ask yourself what if you lose your job? what if you get injured and are disabled even temporarily? Would you have sufficient funds to tie you through a difficult period? If you do and have surplus cash, then by all means pay off your credit card debt or contribute more to your 401k plan even if you have some debts to clear. But if you cannot weather an emergency, then save more for the rainy day.