Learn red flags to watch out for that could prevent you from building wealth and solutions to turn around your financial life.
Debt is a powerful tool that can help or hurt your finances depending on how you use it. Savvy consumers know how to leverage low-interest debt to purchase assets that are likely to increase in value over time, such as a home or business. Education debt can also pay off over time if it allows you to earn more.
But many people abuse debt and allow their finances to get out-of-control. In this post, I’ll cover 13 warning signs that you may have a debt problem. You’ll learn red flags to watch out for that could prevent you from building wealth and solutions to turn around your financial life.
Hello, my friends and welcome back to the money girl podcast. I’m Laura Adams your host and personal finance expert back in your ears with another weekly episode. My mission is to help you live rich and loved the journey.
I am so grateful that you’ve downloaded the show I think it’s gonna be a really good one. I’m gonna answer a voicemail question about how to know if you should continue saving for retirement or stop saving for retirement when you also want to get out of debt? Maybe you feel a little competition between those two desires. This is a great question because it’s a pretty common dilemma that I think many of you are probably struggling with. It’s critical to save for retirement and to pay off debt. But with only so much money to go around knowing exactly where to focus and how much of your money to focus on each of those can be a little bit tricky. So in just a moment you’re gonna hear the question and I’ll give you a five-step guide to follow when you’re just not sure how to manage your money or how to allocate the money that you have. You’re going to come away with a very clear path for prioritizing your precious financial resources so you can build wealth faster.
This is episode number 607 called should you stop saving for retirement to get out of debt?
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Alright here’s our voicemail question:
Hi, Laura, it’s Heather, living in Seattle in my 30s and I’m kind of looking for some more advice about retirement and getting out of debt. I am in a place where I have very little retirement I work for a non-profit and I contribute to my ira right now not my ira my 403 b. However, there’s no match so I’m just contributing about 4% right now because I’m still fighting out of debt. My question is: do I stop all contributions to retirement while I’m getting out of debt and use that money to fuel my repayments or to continue investing or even increase my investing my retirement while I’m paying debt off. Thank you so much I love your show. I listen to it when I go a lot for work so it’s perfect for me. It’s given me so many great tips and tricks so I really appreciate your help and guidance.
Heather thank you so much for calling in your question. Let’s get started with the five steps that I think will give you a lot of guidance about what to do.
Step number one is to evaluate your savings. And, I receive a lot of questions from podcast listeners and readers about paying off debt. There’s a lot of confusion about which debts to tackle first, how aggressive to be, and ways to balance paying off debt and saving. But, I’m gonna tell you before you spend too much time agonizing over all these details. You’ve got to take a step back. I want you to take a holistic view and first evaluate your savings. Do you have a cash reserve? If so, how much is it? Building some amount of emergency savings is it’s just got to be your number one financial priority. Creating a cash reserve needs to come before paying down debt. It’s got to come before investing so that you’re protected from any kind of financial emergency. If you’ve got savings, that really can be the difference between surviving some kind of hardship, like an unexpected medical bill or losing your job. Or getting buried underneath that hardship and maybe even going further into debt. The amount of emergency savings you need will vary depending on your lifestyle in your financial situation. For instance, let’s say you work in an unstable industry, you know you just don’t have a job that you could say it’s really stable, or maybe you’re self-employed and your income varies a little bit for month-to-month, or you’re the sole breadwinner for a large family. In those cases, you probably need a larger financial cushion than a single person who has no dependents and maybe plenty of job opportunities. Ideally, you should accumulate a minimum of three to six months worth of your living expenses. Or another good rule of thumb to use is to save at least 10% of your annual gross income. For instance, if you earn $50,000 per year, make a goal to accumulate and maintain a minimum emergency fund of $5,000. Now, if you’re starting with nothing, you’ve got zero saved up for your cash cushion, you could begin with a small goal. I don’t want you to feel overwhelmed. You know when you’re talking about an emergency fund it’s better to have something than nothing. So maybe you create a small goal such as saving 1% or 2% of your income each year. Or you could start with a small flat target like five hundred dollars or a thousand and then increase it each year until you have a healthy cushion. So don’t feel like you’ve got to have this financial cushion right away, like six months or a year. It may take you a few years to accumulate it but, that’s okay. You just got to get started. If you try to accomplish other financial goals before you accumulate a cash reserve, even a small one, is that you’re putting the cart before the horse. So you want to evaluate how much savings you have, how much you need and then create a plan to bridge the gap. A common mistake to avoid is investing your emergency savings or thinking that you can just tap your retirement fund if you need some extra money. Your emergency fund should always be kept in a very safe place like a high-yield FDIC insured bank savings account. You don’t worry about growing that savings don’t worry if it’s earning very little or even no interest. The purpose of your emergency money is to be accessible and liquid in the short term. If you invested it the value could literally shrink to nothing the moment that you so desperately need to use those funds. So you don’t want to expose those emergency funds to any amount of risk. Being financially responsible means that you are prepared for a day when bad luck may strike. It happens to all of us. Think of your emergency fund as an investment in yourself and that’s going to ensure your future financial safety and happiness. So if you or heather don’t have enough savings in the bank to handle an unexpected hardship. That is your first financial task. If you’re struggling to build up some emergency savings, I want you to automate this process. You might have a portion of your paycheck direct deposited into a savings account. Or you could set up an automatic recurring transfer of funds from your checking account into your savings account. Maybe that might be an option if you’re self-employed.
All right moving on to the second step which is, fill your insurance gaps. In addition to having that emergency fund, a really really essential part of being prepared for the unexpected is being adequately insured, and I think a lot of people get into debt in the first place because they don’t have enough insurance or they don’t have the right kinds of insurance. So these definitely include a health plan, disability insurance, and a renters policy. I’m not mentioning homeowners here because typically you have to have homeowners policy when you have a mortgage. But if you are somebody who owns your home outright, you may also need a homeowner’s policy. As you earn more and as your net worth increases, you’re going to have more income and assets to protect from unexpected events and catastrophes. If you don’t have enough insurance, you know an accident a natural disaster like hurricane durian or a lawsuit, could jeopardize your financial security and happiness pretty easily. And if you think that you can’t afford insurance, like a health policy. You want to shop the federal or your state’s marketplace. They are going to offer coverage and a reduced price based on your income and your family size. So you may be eligible for a subsidy based on your situation that makes the cost of health insurance much less. And as I mentioned disability insurance, that’s another important yet often overlooked coverage that every single earner should have. Disability replaces some amount of your income. Such as sixty percent of it or seventy percent of it if you can’t work due to a covered disability, illness, or accident. Remember, that health insurance only pays a portion of your medical bills. It’s not going to pay your living expenses such as housing or food or any other bills if you can’t work while you’re recovering after some kind of issue. So don’t forget about disability coverage.
Moving on to step number three which is, address your dangerous debts. After accumulating some amount of emergency savings and making sure that you’ve got the right types of insurance. Your next financial priority is to get rid of, what I call, dangerous debts. The dangerous debts that you might have could be tax liens, overdue child support, or accounts that are in collections. So if you’ve got any of these types of serious debts, you definitely need to get caught up on those as quickly as possible. So these are an exception. These are debts that you really want to address. Right after you’ve got some amount of emergency savings, right after you’ve got some good insurance, get to your dangerous debts. These might also include very high interest credit accounts. So it could be a payday loan. It could be a credit card that is in the double digits. Car loans in the double digits. These accounts can destroy your financial health because they definitely drain your resources and they keep you from using your money for other good things like saving or investing. And in general, it’s best to tackle your highest rate debt first because it’s costing you the most in interest. But don’t worry yet, about paying off low interest debts like mortgages, home equity lines of credit, or student loans. Don’t worry about paying those off ahead of schedule because they’re relatively inexpensive. Additionally, they typically come with some built-in tax deductions, which further reduces their cost on an after-tax basis. And this is something i talk a lot more about in my newest book called “debt free blueprint how to get out of debt and build a financial life you love” if you want to really go into some advanced strategies for tackling debt quickly and in the right order, I definitely recommend that you pick up a copy of my new amazon number one release. Again, “debt-free blueprint”, you can get it as a paperback and ebook or an audiobook.
And before we cover the last two steps i want to thank the sponsors who help keep money girl going today’s episode is supported by bank of america interested in making financial lives better through the power of every connection whether it’s sending kids to college building a dream home or planning for retirement as a merrill financial advisor you’d be an advocate for the power your clients have to realize their goals and dreams on a daily basis take the first step by joining the financial adviser development program at careers dot bankofamerica.com today’s episode is also sponsored by campaign monitor at campaign monitor basic email marketing and made it radically easy so big thinkers can focus on what they do best developing big ideas campaign monitor is simple and straightforward to use they have an easy to use email builder flexible pricing plans and a free trial choose from hundreds of professionally crafted templates and turnkey designs to create email marketing campaigns that get real results and you won’t believe how fast you can get a campaign up and running their drag-and-drop email editor gets the job done in a record time that way you don’t have to sweat the small stuff you can focus on what your business is meant to do join the 250,000 organizations that are hitting big business goals with campaign monitor and take advantage of digital marketing most successful channel get started with your free trial at campaign monitor calm that’s campaign monitor calm campaign monitor make your emails and business unforgettable
All right we’re back on step number four for how to manage your money. Step number four is, invest for retirement. So after you’ve prepared for the unexpected with savings and insurance and you’ve dealt with any dangerous debts, it’s time to turn your attention to retirement. As I previously mentioned this is a higher priority than paying off an inexpensive, low rate debt, such as a mortgage or student loan ahead of schedule. Why, well the earlier you begin saving for retirement the better. Not only does starting early give you a lot more time to make contributions but, you leverage the power of compounding interest. Compounding, this is definitely some financial jargon, but what it means is that your earnings, earn their own earnings. So you’re earning growth on top of growth and that’s when your account value can really mushroom. Let’s say you invest $500 a month over 20 years and you get a pretty good return. At 10 percent average return, you would have about 380,000 dollars in the account after those 20 years of investing. Now, if you started five years earlier and invested the same amount, five hundred bucks a month but over 25 years, for five more years with the same return, you’d have a lot more money. You would have over 665,000 dollars. But, let’s say you invest for thirty years you would end up with an impressive nest egg worth over 1.1 million dollars. So, in other words, investing five years earlier can give you an additional four hundred thirty-five thousand dollars just by getting started sooner rather than later. That can make the difference when it comes to the compounding growth that happens in your account. And that can make the difference between scraping by in retirement or having a very comfortable retirement. So if you have a retirement plan at work, maybe a 401 k or a 403 b, that’s the first place that your money should go. And for this year for 2019, you can contribute up to $19,000 or up to 25,000 if you’re over age 50. And if you don’t have a workplace plan, don’t worry about that. Anyone with earned income can have an ira. And for 2019 you can contribute up to $6,000 or $7,000 if you’re over age 50. And if you happen to be self-employed, you’ve got even more options. You’ve got a sep-ira or a solo 401k that you can use for much higher contribution limits. And in general, you can even max out multiple retirement accounts in the same year. I would say that my best advice when it comes to investing is just to always invest a minimum of ten to fifteen percent of your gross income for retirement. If you do that consistently over decades you’re gonna be in a very good place. For instance, if you earn $50,000 a year set aside no less than $5,000 per year for retirement. As I mentioned if you do that consistently over several decades you can retire with at least a million dollars. Now if saving that much seems out of reach, if 10% is just, you know, you’re like Laura, I can’t do that much. Simply make sure that you enroll in a retirement account and start making small contributions. Even investing twenty-five dollars a month is better than nothing. You’ve just got to get started. And until your regularly investing some amount for retirement, even if it’s a small amount, I don’t want you to even think about paying off non-dangerous debt ahead of schedule. Put your retirement ahead of your creditors. Otherwise, you risk starting too late and not having enough time to catch up for retirement.
So in the next step, I’m going to help you figure out how much to allocate to both your debt and to retirement. So our last step, number five is, pay off debt by interest rate. So once you’re prepared for the unexpected and you’re consistently investing for retirement, then it’s time to tackle your debt. But as I’ve mentioned, not all debt is created equal. You’ve got some dangerous debts. You’ve got those high interest debts. But you’ve also got low interest debts, that are not, not quite so bad. So you need a strategy to choose the best accounts to eliminate first. And your goal should be to figure out what’s more profitable. Is it more profitable for you to save the interest that you’re currently paying on the debt. Or investing your money with the expectation that it will grow. So you’re gonna ask yourself which option will give me the highest return on my money. Paying off debt gives you a straightforward guaranteed return. For instance, if you’re carrying debt on a credit card that charges twenty-six percent interest, paying it off gives you an immediate twenty-six percent return. You would be very hard-pressed to find an investment that would pay you a twenty-six percent return after taxes. So paying off a high rate credit card debt is a no-brainer. That’s a much smarter financial move than investing. But, as I previously mentioned, you do not need to be in a rush to pay off debt with low interest rates. So maybe you’ve got a four percent mortgage or a five percent student loan, don’t pay those off ahead of schedule. Plus, these two types of debt also come with tax breaks that make them even less expensive on an after-tax basis. In general, you are better off investing money than using it to pay off a low rate debt. You’re gonna earn more by saving and investing for retirement then you could by eliminating the interest expense on those low rate debts. Additionally, you may have other financial dreams. Maybe you’re saving to buy a home or sending kids to college. Once you’re consistently setting aside money for retirement and you have eliminated dangerous expensive debt, you may choose to fund other goals instead of paying off inexpensive debt. So a lot of this comes down to what your goals are and what your financial situation is.
So let’s get back to heather’s question about whether she should stop making retirement account contributions to get out of debt faster. I don’t have a whole lot of details about her situation but in general, I hope I’ve made the case that the answer is no, don’t stop investing. Don’t put your creditors best interests ahead of your own. Not saving for retirement is just too risky. The only exception is going to be when you’ve got dangerous expensive debt to address. When you’ve got debt with double-digit interest rates such as a twenty-six percent credit card or a 12 percent car loan, there’s no debating that you should wipe it out as quickly as possible. Just tackle it while simultaneously saving some small amount for retirement, don’t stop the momentum on your contributions, you may want to scale them back while you tackle those dangerous debts. But before you prepay a low rate debt, especially one that comes with tax deductions, consider that saving for retirement is usually a smarter move over the long term. So I would rather you max out that retirement account before you pay off a mortgage or before you pay off a home equity loan. Plus prepaying a low interest loan could leave you cash poor, and that would not be good in the case of an emergency, you know unless you’ve got a very healthy emergency fund. You know it’s called personal finances because the best choice for you depends on your risk tolerance and your feelings about debt. Once you take care of yourself by building an emergency fund, having insurance, and investing some amount for retirement, how you prioritize extra money is really your call. Just make sure that how you spend money aligns with your values and it always moves you closer to achieving your financial goals.
If you have a money question or an idea for a future show topic, I would love to hear it. We have a voicemail line if you’d like to call in your question or comment just like heather did. Call three zero two three six four zero three zero eight to leave your message. Or you can send me an email by visiting my contact page at Laura D Adams dot com. Be sure to join me next week for a special episode. You’re going to hear my interview as a guest on another podcast, where I’m talking about my favorite ways to save money around the house. Be sure to subscribe to the money girl podcast so you’re notified when each new show episode is available. Money girl is produced by the audio wizard Steve Rickeybur, with editorial support from Karen Hertzberg.
If you’ve been enjoying the podcast please rate and review it on apple podcasts. That’s such an easy way to give back and show your support. You might also like the backlist episodes and show notes that are always available at quick-and-dirty tips dot com. That’s all, for now, I’ll talk to you next week. Until then, here’s to living a richer life.
1. You don’t know what you owe.
If you don’t know how many debts you have or their approximate balances, you need a reality check! If you’re avoiding opening your bills or looking at credit card statements because you don’t want to see the balances, then you already know you have a debt problem, and it’s time to do something about it.
Take the time to create a spreadsheet listing each account name, number, interest rate, and the amount owed. In general, it’s best to tackle debts with the highest interest rates first, such as payday loans and credit cards, since that gives you the most potential savings.
Hiding from a financial problem doesn’t make it go away. Knowing where you stand with debt is the first step to getting it under control and improving your entire financial life.
2. Your debt-to-income ratio is too high.
Your debt-to-income (DTI) ratio is a key formula expressed as a percentage that lenders use to evaluate you, and you can use it, too. To figure it out, add up your total monthly debt payments – including credit cards, loans, and your rent or mortgage payment – and divide that amount by your gross (pre-tax) monthly income.
For example, if you earn $5,000 and your debt totals $2,500 per month, your DTI is 50% ($2,500 / $5,000 = 0.5). Most lenders consider a DTI above 40% too high, especially when you’re applying for a mortgage. So a 50% DTI means that you have more debt than you can handle for your income.
But even if you don’t plan to buy a home or get a large loan anytime soon, calculating your DTI is a good way to monitor your financial health. Watch it over time to make sure that it decreases and never goes up.
The solution to a high DTI is to pay off debt by cutting expenses, increasing your income, or doing both. Additionally, paying down your outstanding debt balances boosts your credit. That may allow you to qualify for debt optimization tools, such as a balance transfer credit card or a low-interest personal loan.
Is credit card debt keeping you from success? Learn how to get your debt under control.
3. Your interest-to-income ratio is too high.
Another revealing ratio compares the total of your monthly interest charges on all your debts to your gross income. If it’s more than 20% of your monthly income, take quick action to reduce it.
Paying high inters rates on debt means that you may not have enough left over each month to cover your basic living expenses, such as housing, food, and transportation. Try shifting balances to a low-rate personal loan or taking advantage of a 0% interest balance transfer credit card to get some financial breathing room.
4. You can only make minimum payments on cards.
If you’re stuck in a cycle of only paying the minimum on credit cards each month, that indicates you have a debt problem. As interest accrues, you could end up paying double or triple the original cost of the items charged on the card.
For example, let’s say you have a $5,000 card balance with an 18% annual percentage rate (APR) and a $100 minimum payment. If you only pay the minimum, it will take you over 30 years to eliminate the balance!
But if you pay $250 per month, you’d pay off the balance in under nine years. And paying $500 would allow you to eliminate the debt in just over four years.
These pay-off time frames assume that you don’t increase credit card balances with any additional charges. So, make a plan to stop making new charges and to pay as much as possible on credit cards each month to get out of debt as quickly as possible.
5. Your credit cards are maxed out.
If you’re using credit cards to satisfy a shopping habit or to buy necessities during a financial rough patch, you’ll eventually hit your credit limit. You may be charged additional over-limit fees if purchases exceed your credit limit.
Even if you can pay more than the minimum payment each month, having a maxed out card causes your credit utilization ratio to skyrocket, which kills your credit scores. If you’re consistently using more than 20% to 30% of your credit lines, you probably have a debt problem that needs to be reined in.
If you’re living beyond your means and financing a lifestyle that you can’t afford, it’s time to create a realistic spending plan and take control of your finances.
6. You can’t pay bills on time.
If you’re not paying bills on time, it could be because you’re extremely unorganized. But it’s more likely that your debt payments are more than you can afford to pay each month.
Ignoring bills may make you feel better in the short term, but I promise that they’ll come back to bite you in the form of late fees and bad credit. Paying late only makes a debt problem worse.
Contact your creditors to discuss any financial hardship and ask for their help. You may be able to work out a payment plan to get caught up with past-due balances or have late fees waived.
7. You’ve borrowed to pay your bills.
If you have to borrow money from friends or family or take cash advances on credit cards, you certainly have a debt problem. Getting cash from a credit card is the worst way to use it because you’re charged a higher interest rate than for regular purchases. Additionally, you usually get hit with a cash advance fee.
Eventually, you’ll run out of places to borrow and you’ll have to face the balances you’ve racked up. So, make a plan now to reduce your expenses and increase your income sources so you live within your means without having to borrow from loved ones or expensive creditors.
8. You overdraw your bank account.
I don’t know too many people who have never accidentally bounced a check – even me. However, if you’re paying expensive non-sufficient funds (NSF) fees on a regular basis, it’s probably because you’re spending more than you make and have a debt problem.
The cure is to create a budget so you know what your expenses are and how much you earn. Aggressively cut back on all unnecessary expenses and brainstorm ways to increase your income at the same time.
9. You don’t have savings.
Even people who aren’t in debt can make the mistake of not saving. But if you’ve drained a savings or retirement account to pay off debt or to pay for everyday living expenses, that’s when you know you have a debt problem.
If you don’t have savings, you’re living on the edge, financially speaking! Any unexpected expense could send you into a tailspin that causes you to go further into debt. Make a plan to radically cut your expenses and begin setting aside as much as possible each month in an FDIC-insured savings account.
Having cash on hand is the best way to avoid having to use debt in the first place. It’s how you’ll keep your head above water if you have a large unexpected expense or loss of income.
Make a habit of saving (even small amounts) to your emergency fund. Start by setting aside 1% of your income until you have several months’ worth of living expenses as a cash cushion. Then make a goal to save a minimum of 10% to 15% of your gross income in a retirement plan at work, an IRA, or a retirement account for the self-employed.
10. You’ve been turned down for new credit.
If you’ve recently been denied credit or can only qualify at a high rate, you may have poor credit, too much debt, or both. Review your credit using a free site such as Credit Karma or AnnualCreditReport.com to make sure there isn’t any incorrect information on your credit reports.
To learn more about how credit scores are calculated and how to raise your credit, read or listen to the podcast version of 7 Essential Rules to Build Credit Fast.
11. Your finances cause you to lose sleep.
If you’re so worried about your debt and bills that you can’t sleep at night, you certainly have a problem. Financial stress can lead to trouble focusing on your work or poor health.
Losing your job or business income is the last thing you need when you already have money problems. So, make a plan to deal with your debt and get your stress under control as quickly as possible.
12. You lie about your finances.
If you’re lying to family or friends about your spending habits or how much debt you have, it’s because you know deep down that there’s a serious problem. If you’re worried, losing sleep, and having trouble concentrating due to debt, it’s time to take action.
Create and stick to a realistic budget, make an appointment with a financial planner, or see a debt counselor. The National Foundation for Credit Counseling at NFCC.org is a great resource.
The only way to improve a bad situation is to be brave and face it head-on. Denying a debt problem only makes it worse and prolongs your agony! The sooner you address it, the sooner you’ll make positive financial changes.
Is your credit rating holding you back? Find out how to fix it.
13. You’re getting calls from debt collectors.
When debt collectors start calling you, your debts are seriously delinquent and you have a big-time debt problem. If you don’t face past due debt head-on, you could end up in a lawsuit, have your wages garnished, have your home foreclosed, or have a vehicle repossessed.
Be cautious about communicating with a collector on the phone. Even a short conversation is risky because you could accidentally say something that gives them a leg up or resets the statute of limitations on an old debt.
Never admit that you owe a debt or engage in conversation or debate about the issue. Just ask for the company name and address and say you will only communicate through the mail, and then hang up. Always get professional help from an attorney who can help you understand the collections laws in your state and help you navigate wise options.
To sum up, the problem with debt is that it puts unnecessary strain on your finances that keeps you from making positive progress, such as building an emergency fund, investing for the future, and reaching your financial goals.
Never go into debt for anything that doesn’t give you a return – like consumer goods, dining out, or fancy vacations. Financing those types of purchases, especially on a high-interest credit card, causes you to lose wealth instead of to build it.
So, if you’re wondering if you have a debt problem, you probably do. Lenders are usually willing to dole out more debt than you should have. Setting limits is your responsibility.
The good news is that if you recognize these warning signs, it’s never too late to turn around your finances, pull yourself out of a debt hole, and make better choices.
Published by Debt.com, LLC