Amber writes in with the following question regarding Roth IRA withdrawals:

“I currently owe about $10,000 in credit card debt and have nearly that amount in a Roth IRA I started a few years ago. I share your passion for being debt free and have considered withdrawing the money from my IRA account to pay off my debt. I figure once I’m debt free I can resume Roth IRA contributions and rebuild my account. Your thoughts on this strategy?”

Thanks for writing Amber. I appreciate your desire to become debt free – there is no feeling like it! However, withdrawing money from your Roth IRA to pay down debt could potentially be a bad move. Let’s discuss why.

Four Reasons Not to Tap Your Roth IRA to Pay Down Debts

You might have to pay a penalty if you withdraw from a Roth IRA. Although you can withdraw your contributions to a Roth IRA at any time and for any reason, you will be penalized if you withdraw earnings on your Roth IRA contributions unless the distribution of earnings is qualified.

A distribution is only qualified if you withdraw on or after the date you reach the age of 59 ½; if the withdrawal is made because you become disabled according to the IRS; if the withdrawal is used toward the purchase of a first home; or if the withdrawal left to your beneficiary in your will. The withdrawal of earnings must also be made five tax years or more after your first contribution.

Clearly, most withdrawals of earnings to pay off debt are not qualified. A distribution that is not qualified will be subject to a ten percent additional tax penalty, and you must pay ordinary income taxes on the amount you withdraw. There are no taxes owed on qualified distributions from a Roth IRA.

You diminish the power of compounding interest if you withdraw from a Roth IRA. Even if your distribution is qualified, you will have a smaller balance after you withdraw. This makes for a lower amount of money that can be earning interest, diminishing your returns over time. Once you withdraw contributions from previous tax years, they cannot be reinvested. That opportunity to contribute for that period is gone, forever.

You might be unprepared for retirement if you withdraw from a Roth IRA. A Roth IRA is designed to help you pay for your living expenses when you can no longer work. Withdrawing money from it today may leave you with less money decades from now, increasing the odds of an impoverished retirement.

You may start a bad financial pattern if you withdraw from a Roth IRA. It will likely be easier to withdraw from your Roth IRA again in the future when you need some quick cash after you take your first early distribution. Withdrawing once may start a bad pattern that will keep you from hitting your retirement goals if you make a habit of tapping retirement contributions to pay for your current lifestyle.

All things being equal, it seems best to avoid withdrawing from a Roth IRA to pay off your credit cards and other consumer debts. If you have no other recourse, and your debt is inhibiting your ability to live today and plan for the future, then you might want to take a withdrawal.

If you decide to go this route, I strongly suggest you only remove contributions from your Roth IRA, not the earnings. Allow the earnings to continue to grow, and avoid paying taxes and penalties for withdrawing them early for a non-qualifying event.

The current economic and political climate, as well as the projections for the near future, have convinced me of one thing – there has never been a better time to get out of debt and build an emergency reserve of cash. That’s right, the day of debt reckoning has arrived.

Yes, I do say that to alarm you. I think people need to be alarmed. Some people need to take off their rose-colored glasses, remove their political hats, ignore their favorite celebrities, and look at the stark reality we face. Our country is bankrupt. We are at war. We are tearing ourselves apart along the lines of Left vs. Right, and they have both been wrong.

I don’t know what might happen in the next year or two. None of us do. However, I do know this – those who have freed themselves of the burden of debt, built an emergency fund, and made adequate preparations for a worst-case scenario, are those likeliest to succeed – even thrive – in the coming years.

This is where I differ from others in the personal finance realm. I think the number one priority for anyone, particularly those with a family with people depending on them, is to build a six-month emergency fund of liquid cash to cover basic household expenses (food, rent/mortgage, utilities, transportation). I don’t care how much debt you have. I don’t care how much interest you are paying. You have to start building a cash reserve…now.

Why a six month emergency fund? The average unemployed person in America has been looking for work for 39.7 weeks, so we really aren’t even covering that full period of average unemployment, but it’s a start.

Most disability insurance policies have a six-month waiting period. If you get sick, or are injured, and cannot work, it will likely be six months before your disability coverage kicks in.

Why not nine months, or a year? If you are still deep in debt, you must start paying down that balance. Six months of savings is a good point to make the switch from savings to debt repayment. Once completely debt free, I think everyone should have a full 12-month emergency fund.

The Four Pillars of Paying Off Debt

1. Pick a plan, any plan. There are plenty of “get out of debt” plans floating around out there. A couple of my favorites are the debt snowball, made popular by Dave Ramsey, and the Debt Tsunami, which advocates giving an even higher priority to emotions elicited by a particular debt, and using that emotion to prioritize a repayment plan.

Both plans largely ignore interest rates, unless everything else is equal, as a determining factor in which debt should repaid first. I generally agree with this approach, as the emotional “win” from paying off a low-balance debt quickly is more valuable than paying a little more interest on a larger balance.

However, I don’t think completely ignoring interest rates is the perfect solution either. After all, paying down a large credit card debt at 19% interest while making the last nine minimum loan payments on a 3.99% car loan with a smaller balance seems to make a lot of sense, from purely a financial perspective.

On the other hand, paying off that small car loan balance in three months, and freeing up another $400 a month that used to go towards car payments, may provide a quicker win in your own plan. Do what works for you.

2. Keep it simple. Whatever plan you choose, my best advice is to keep it simple. The more elaborate the plan, the less likely you are to stick with it. That’s just human nature.

Ask anyone who has tried (and failed) elaborate diets how successful they were month after month. Chances are, somewhere along the way, they slipped. Not that slipping is necessarily bad – we will all do it, but if we have a simple plan to begin with, it makes it that much easier to get restarted.

3. Stop spending. This one is probably the most obvious, but it also the most difficult. People who spend more than they earn on non-essential items are often trying to fill an emotional void. That was certainly my case. I bought stuff because it made me feel good, because I was bored, and because I was trying to keep up with others who made much more money than I did.

Of course, others are swiping their credit cards because they have no cash, for a variety of reasons – some quite legitimate. This prolonged recession (when will we finally admit this is a depression?) has left many, many people unemployed and under-employed. In fact, a record 44.7 million people are now receiving food stamps.

That means a lot of families out there are having to decide between swiping the credit card, or going without food, gasoline in their cars or paying an electric bill. Chances are, many of these families have already cut most frivolous spending from their budgets. If not, or if you find yourself in debt, but not to the point of having to ask for assistance, I plead with you to radically change your spending habits and start working to pay down debt (after establishing a minimum 6-month emergency fund).

4. Increase your income. Earlier, I mentioned #3 was by far the hardest step. However, in today’s climate increasing your income is a very close second. Many families have been hit by layoffs, with one or both spouses losing their jobs. Self-employed people have seen work dry up, particularly those involved in residential construction and similar industries.

I think we are living through a monumental shift, a turning point. For the last 50-60 years many families made their living by working at a factory, or for a city, or a utility or similar, large institution. They were offered pensions and health benefits after reaching retirement. Their jobs were relatively stable, as was their income.

However, things are changing. Many manufacturing jobs have left, and will likely never return (at least not in our working lifetimes). Politics have made public-funded pensions and benefits an endangered species, and likely a thing of the past. No longer can one count of getting a college degree, finding a job and working there for 30 years until retirement.

New generations will have to be much more adaptable, much more creative in their ability to earn a living. They will have to create a variety of income streams by cultivating a combination of their personal and professional talents and interests.

• White-collar professionals may find themselves building privacy fences and decks on the weekends (or going full-time with a popular blog).
• Teachers may host tutoring workshops after school to earn extra cash.
• Policemen may start landscaping companies to supplement their income.
• Nurses may offer to watch an elderly person in poor health to relieve caregivers.

The possibilities are endless, and in reality, we already see many examples of these types of things happening. The difference is that in the past we looked at people with two careers (or a side hustle) as a bit odd – like they were workaholics or people lacking the ability to pick a career path and stick with it.

Going forward, this will be the norm. And those not looking to diversify their income will be the hardest hit every time there is a downturn.

Get creative. Coordinate a block yard sale with neighbors and split the advertising costs. Build a blog about whatever it is that interests you and write about it. Engage with others online in your area of expertise or fields of interest. Ask your current boss if there are any overtime opportunities. Put in applications for part-time work.

Use every single extra dime you can scrape up to put towards that 6-month emergency fund, and then towards your debt repayment plan.

I’ve never been more convinced that this is the time to get out of debt. And if I’m wrong, and things suddenly turn around and the economy booms, you’ll still be better off without debt and a solid emergency fund.

You will be able to seize opportunities others can’t. You will free up income to make investments others will miss (yes, I’m still bitter about being in debt back in 2008 and missing the many opportunities during the “recovery”).

The bottom line is this…you have to start today.

Ignore the television tonight, sit down with a pad and pen and list your debts. Figure out how long it will take to save six months of basic expenses. List things you can sell to make that happen even faster. Brainstorm ideas for increasing your primary income, and for creating new income streams. Now’s the time.

But it has occurred to me lately that I know much less about the larger world of personal finance than I thought I did. At times I feel like a complete novice. I used to think the only thing holding me back was debt. “If I ever reached debt freedom I would become a millionaire in ten years,” I thought.

If only I were debt free. I’d throw caution to the wind; start my own business; invest in hot stocks that I missed out on while paying down debt. The truth is that paying off debt changed very little.

The anxiety I used to feel from the debt cloud hanging over me has been replaced by the anxiety I feel trying to preserve, and grow, what little bit of savings I have managed to pile up since then.

I worry about losing money. I worry about not earning enough money. I worry about losing my job, or getting sick, or being able to provide for my family in an emergency. Sure, those worries are not as intense thanks to debt freedom and an emergency fund, but they are still there.

It’s actually a little depressing. It reminds me of the feeling you had on Christmas morning, when after ripping open the large, red box in the corner, you realize that Santa Claus brought you that toy you have been wanting all year long. It’s euphoric…for a few hours.

By that afternoon you were tired of that new toy, and sad because it would be 364 days until Christmas came around again.

I don’t mean to discourage anyone from paying off debt. I think short of building a basic emergency fund, paying down debt is one of the smartest moves anyone could make right now, given continued economic and job market instability.

However, I also wanted to paint for you a very real picture of what life after debt freedom looks like. It’s not an absence of money worries. The worries just change. In fact, I would argue that certain worries intensify, because you no longer have debt as an excuse to get busy on your goals. I used to say things like,

• “We’ll start saving for retirement after we get out of debt.”
• “It would be nice to contribute to the kids’ 529 college savings plans, but we can’t while we are paying off credit cards.”
• “We will pay cash for our next car, but for now we’ll have to borrow because I can’t save up that much cash AND pay down debt.”

It is almost as if debt became an excuse to acquire more debt, or not save and invest. Once the debt is cleared, you have to purge that thinking from your mindset. And that is hard.

It’s also hard to continue living on a slimmed-down “debt” budget when you no longer have payments. The increase in disposable income forces you to make decisions and engage willpower that wasn’t really required when sending most of your paycheck to banks and credit cards companies (assuming you were faithfully doing this for some time to get out of debt).

I know what you’re thinking. Increased disposable income, yeah, nice problem to have. And it is. But it also tests your willpower in ways it hasn’t been tested in some time. Actually, if you were like me, and in credit card debt as soon as you were old enough to sign up for one, your financial willpower may never have been tested at all.

Maybe this is why some people who pay it off go right back into debt. Or why lottery winners are bankrupt in only a few short years. Or why dieters who lose 100 pounds gain back 110 pounds. It’s because our behaviors never changed. Once the euphoria of reaching our milestone wears off, life begins to happen again. You are tested.

Preparing for Life After Debt

If I had known this ahead of time, I probably would have left some of the same tools in place that I used to keep myself in check while in debt. Instead, we took off all the restraints, and in a couple months found ourselves spending way too much on our credit card (we paid it off every month, but thanks to overspending it caused us to stretch and even dip into savings on one or two occasions). I wasn’t happy, and immediately worried we had returned to our old ways.

Fortunately, we were aware of what was happening and managed to keep the train on the track. These days, we are again focusing our attention on what we spend and trying to reduce that amount each month. We aren’t quite as strict about things as we were when we were in debt, but we make the effort to spend more intentionally.

My anxiety over investments and college savings and emergency planning, etc, etc. has subsided some as well. We’re saving for retirement, adding some to the kids’ college plans, and fortunately, have time to let all the dips and dives in the market work themselves out over the long haul.

We invest conservatively for our age, but it helps me sleep at night – a sacrifice I’ll gladly give up for a couple percentage points in returns.

If you are currently in debt, I hope you are working to pay it off and enjoy a debt-free life. As you move closer to your goal, begin to think about how your life will look once you are back to even.

Create a debt free “dream” budget to imagine how your expenses would look without any payments. Start researching various investment opportunities that might interest you when you have the money to invest in them.

Think back to all the things you wanted to do while still in debt and make plans for those things, too (take vacations, look for a more fulfilling job, donate to a charity that you feel passionate about, or maybe help a friend or family member).

Above all, remember it’s OK to loosen the reigns a bit, just be sure not to completely let them go.

*According the photographer, this picture was taken on January 1, 2009. Since then, we’ve added nearly $2.5 trillion to this figure.

What used to be practically an automatic stamp of Congressional approval (the debt ceiling has been raised 74 times since 1962, 10 of those times since 2001) has now become a line in the sand some conservative politicians have refused to cross.

Experts disagree on the outcome of a failure to increase the debt ceiling, but it seems the worst case could be a default on the debt already owed, resulting in an increase in the cost to borrow future dollars. Repayment of existing debt would be difficult without raising the ceiling because much of the new debt is created to pay interest on debt we already owe.

Imagine asking for limit increases on your credit cards so you can borrow money to pay your other credit cards. Well, multiply that example by a trillion and you can understand the magnitude of the problem.

My Personal Debt Ceiling

Rather than worry too much over things I have little control, I have instead decided to focus my energy on my own personal debt ceiling. My personal “line in the sand,” an amount beyond which I refuse to borrow.

My own debt ceiling has shifted a bit as I’ve matured, financially. I suspect that’s the case for most of us. Some may raise their debt ceiling as they grow older, believing in the idea that having debt is normal – you can’t buy a house or a car without debt.

Others have recognized early on that being in debt stinks, and vow to never go back. We found ourselves in the latter category, and spent a couple years clawing our way out of debt. Our new family motto when it comes to debt – “Never again.”

Debt Creep

When I was young I used to read stories about people being $10,000 in debt. I couldn’t imagine how much that must have weighed down borrowers. These days, it’s nothing to hear of people owing over $100,000 in student loans and credit cards, or $400,000 on a mortgage, or $50,000 for a new car, or $30,000 on credit cards.

The numbers that are tossed around are as mind-boggling as the discussion on the aforementioned national debt – now some 14.2 trillion dollars and counting. Just how much is a trillion dollars anyway? One trillion is the equivalent of one thousand billions, or one million millions. And we owe 14 trillion! See what I mean by mind-boggling?

Much like dieters hitting a 200lb. (or 300lb.) reading on the scale, I assume most of us have a number in mind that we aren’t willing to cross when it comes to borrowing. A debt threshold. A number, that when approached, finally causes us to change our behaviors and consume less.

For many of us recovering spendthrifts that acceptable debt threshold is zero. For others, a couple thousand on a credit card doesn’t seem too bad as long as they are making substantial payments.

Unfortunately, for a large percentage of our population, that number has increased significantly over the years. Consider the following statistics shared in a recent post at Man vs Debt, Upside-Down Nation: How Debt Fueled Our Madness:

Average 1970s One-Income Family:

$32,000 inflation-adjusted income
Saved 11% of their take home pay on average
Paid 1.4% to revolving credit, such as credit cards or lines of credit.

Average 2005 Dual Income Family:

$73,000 average income
Saved nothing (0%). (Actually, U.S. had a negative savings rate overall at this time.)
Paid 15% to revolving credit, such as credit cards or lines of credit.

Sad. So in three or four decades, as a society, we have doubled our average income, saved nothing, and now spend ten times as much on consumer debt as we did 40 years ago. And notice this study initially only included “one-income” families. Many more households today are two-income households. Some by choice, but many out of necessity – to support an inflated lifestyle. For most families, living on one income has become nearly impossible without making very difficult choices.

We live in bigger homes, drive more expensive cars, and pay more for education. We abandoned the idea of a “starter” home when starting out, as recent generations have felt an obligation to keep up with their parents, or the Jones’, or some independently wealthy 26 year-old heiress they saw on television.

We even have television shows celebrating the idea of newlyweds signing over their financial futures in the form of near half-million dollar mortgages.  

Read: My First Place on HGTV: How to Spend Your Next Thirty Years House Poor.

For now, I think I’ll keep my personal debt limit at zero. Sure, I use my credit card here and there throughout the month to pay utilities, etc, but the day that bill arrives it’s back to zero. I recently bought supplies for a DIY home remodel, and the large expense plus our normal monthly bills pushed the balance well over $1,000.

When I opened the bill, my heart beat a little quicker. I could feel the anxiety welling up inside me. I remembered that same feeling when I used to open similar bills from several credit card issuers. And I hated it. I immediately paid off the credit cards with an online transfer. Never again.

This was the serenity prayer for finances in action. I needed to focus on the things I could change, rather than worrying over the things I can’t (or at least not directly).

For too long I carried credit card debt on a handful of plastic cards that controlled every aspect of my life. The debt represented years of poor financial management followed by more years of sticking my head in the sand and ignoring the debt that had accumulated.

It wasn’t unusual for me to sit down on a Friday evening and send off half  of my take home pay to banks and credit card companies in the form of minimum payments and car loans. You would think seeing 50% of my income disappear would have motivated me to get out of debt sooner, but it didn’t. In fact, a dangerous pattern began to emerge.

Using Frugality as an Excuse to Stay in Debt

Stay with me here.

Because we were living on half of my income, we became masters at frugality. We clipped coupons, reused towels, ate every meal at home, skipped vacations, canceled the cable and on and on. It became sort of a game to see how little we could live on. We got so used to it we became complacent.

It was easy just to send along my monthly payments to the credit card company and live on the rest. Sure, we weren’t making much of a dent in our debt, but we weren’t hurting either. We had plenty of food, a (rented) roof over our heads, a decent car, etc.

Our resourcefulness was now our downfall. Because we were comfortable, there was no push to become debt free. If nothing had changed, we’d still be in the same debt trap we were back then – cash in from paychecks, cash out to credit cards, charge monthly expenses on credit card because we had no cash. Repeat…over and over again, month after month.

Unfortunately, as the debt continued to grow, and the minimum payments consumed more and more of my paycheck, we soon found ourselves not so comfortable.

The breaking point finally came a few years ago when I found myself eating a soggy hot dog from a convenience store on my lunch break because my checking account was overdrawn, my credit card was maxed out, and my wallet was empty. I had to rely on a gas card to buy my lunch. Had I really gotten to that point? Yes.

But it wasn’t just the soggy hot dog that got me to see the light.

It was years of lying awake in bed thinking about what it would feel like to be debt free.
It was the years of getting up every single morning dreading my day at a crappy job that I only stayed at because I felt I had no options.
It was the realization that our debts were taking an emotional toll on our family. I was unhappy. My wife was worried. And our kids could feel it.

We became debt free several months ago now and haven’t looked back. Our family motto is “never again.” As in never again will we go back into credit card debt. From this point forward we will finance our own emergencies, education and occasional luxuries.

If you’re reading this and are in the same state of complacency I found myself in a few years ago, don’t wait for a soggy hot dog to awaken you. Get fired up about getting out of debt.

Back to the national economy. Of course, there is no way for me to predict what might happen to our economy in the next few years. I’d like to think we’ll pull ourselves out of this dive, tighten our belts once prosperous, and begin to repay our obligations. I also recognize this is probably overly optimistic given the hole we’ve dug and the steepness of the climb ahead.

No matter what happens, if your household is a debt free one you’ll weather the storm better than your neighbor who is drowning in credit card debt, paying for a mortgage he can’t afford, and has no savings.

With no debt, and some cash in the bank for emergencies, you can keep the lights on and put food on the table even if you have no income for a while. With no debt you can take advantage of the opportunities that show themselves in tough times.

So sit down today, develop a game plan and get busy becoming debt free.

Anyone in debt at one time or another has faced this same dilemma, but the answer is a difficult one because there are a number of factors in play, including a number of very personal factors.

• What are you overall financial goals?
• How MUCH of this particular debt to you have?
• How long will it take to pay off this “bad” debt?
• Are there emotional strings tied to the debt that are causing problems elsewhere?

Obviously, personal opinions on what is debt (good or bad) vary considerably, too. I personally consider student loan debt a relatively bad debt, but not nearly as bad as IRS debt or debt to payday lenders.

Others consider student loan debt an investment in their future earnings, which I also tend to agree with (to a point), which is why I’d rank student loan debt somewhere in the middle.

I’m sorry to say, I experienced nearly every kind of debt prior to my financial turnaround, so I had plenty of opportunity to develop my own personal debt ranking system. Feel free to use it to motivate you towards putting together your own get out of debt plan.

The Ugly

IRS debt. Of all the “uglies” to owe money, I can’t imagine any being more ugly than the IRS. They can garnish wages without a court order, and outright ignoring them can result in jail time. Not to be messed with.

Car title/payday loans. In my town, I’ve noticed that as the economy has worsened, more cars are in the sign-your-financial-life-away-for-$200-at-300%-interest establishment parking lots. Sad.

Personal loans with baggage. By baggage I mean loans attached to bad relationships, such as owing money on a car you shared with an ex-spouse, or a personal loan financed by your father-in-law, who like to remind you how much you owe him every time you see him.

The Bad

Credit cards. Credit cards, as a tool, can be quite useful. However, credit card debt is vile. When I was deep in debt, I felt like I was working for the bank. My paycheck came in, and just as quickly as it arrived, it disappeared in minimum payments which barely cut into the balances after interest charges accumulated. It kept me awake at night, caused anxiety throughout the day, and limited my opportunities. Bottom line – being in debt sucks.

Upside down car loans. Car loans are not necessarily evil, unless you have no money to put down, buy new and drive off the lot owing more than the car is worth. Getting out of an upside car loan is not easy, so if you do finance a car purchase, consider gently used and using a trade and/or down payment to preserve some equity in the deal.

Enormous student loans. I emphasized “enormous” here because borrowing some money to finish off a degree often yields a nice return, considering college graduates usually earn more over the course of a lifetime. However, I don’t think that is an excuse to rack up over $100,000 in student load debt for a degree program in a field with starting salaries around $45,000.

Business debt. I’ve started and failed at a number of entrepreneurial efforts over the years. Fortunately, the one smart thing I did was not borrow a lot of money to finance these start-ups, so their failure didn’t haunt me for years to come. I recognize that many businesses need to borrow start-up capital to fund operations until revenues are flowing, but doing so puts the business (and employees) at enormous risk.

The (Slightly) Good

Mortgages. In a perfect world, people would be able to save up enough money to buy a home with cash. While that is certainly do-able, it isn’t practical for most of us. So, I concede that a reasonable amount of mortgage debt is not bad (and certainly not ugly).

However, as with student loan debt, the emphasis should be on reasonable. If your mortgage represents more then half your monthly income just because some “creative lender” allowed it, your home will not feel like a blessing. And you think getting out of an upside down car is tough, try an underwater mortgage.

When answering the question, “What is bad debt?” consider whether or not the money borrowed is for something that will appreciate over time. This may or may not be the case with real estate, making mortgage debt an acceptable debt in most cases.

Similarly, student loan debt is a somewhat acceptable form of debt (again, in small doses) as it often leads to higher earnings in the future.

Using that same logic, it’s easy to see why charging groceries to a credit card and not paying them off is bad debt. Three months later, the groceries are gone, but the debt is still around, accumulating interest and causing indigestion.

This post was included in the Festival of Frugality – Spend It Edition

I’m not shy about talking about payday loans. In other entries to my blog, you’ve heard me condemn them up and down, backwards and forwards. (Trust me. I’m not done yet.) I’ve even put them near the top of my list of financial Weapons of Mass Destruction. I can’t say enough about how destructive this kind of lending is. They don’t call it predatory lending for nothing, that’s for sure.

I’ve laid out before a number of reasons why payday loans are a flat out bad idea, so I thought I’d use this entry to go into deeper detail about maybe the most important part of what makes payday loans such a rip off.

The APR. Trust me, it’s absolutely, positively, astronomical.

The Basics of APR

I don’t want to assume everyone knows what I mean by APR, so let me frame it up for you quickly before I get too deep into why payday loan APRs are so horrible. Stick with me for a minute, and I promise – you’ll be able to see for yourself why payday loan APRs are not to be messed with.

APR stands for annual percentage rate. In summary, this is the rate at which your loan accrues interest. In plainer English, this is the amount of money you have to pay beyond what you were loaned. To the person who loaned you the money, this is the profit.

Simply having an APR isn’t bad. Most forms of credit and most loans are made profitable through an APR. It’s a necessary part of the credit industry.

What makes payday loan APRs so ridiculous is how high they are. Percentage rates on these are many many times higher than most other forms of credit reinforcing why you need to avoid payday loans at all costs.

Typical Loan APRs

As I mentioned, most forms of credit have an APR. The difference between traditional forms of credit (like mortgages, credit cards, student loans, etc.) and payday loans is that most traditional forms of credit have at least a somewhat reasonable APR, and a payday loan has an exorbitant APR.

For example, a typical credit card’s APR is somewhere between 7% and 36%. Now, I know that’s a big range, but it goes to show you where someone who doesn’t have good credit would be placed – out at the upper end of the 30% range. Please don’t get me wrong – that’s not, by any stretch of the imagination, a good rate. If you have credit cards at that rate, it might make sense to talk to someone about consolidating your debt. Our current Visa carries a rate of 9.99%, but also remember that we pay it off each month.

For a second example, a car loan APR is usually somewhere between 5% and 15%. 15% is certainly on the very high end, but again – I bring it up because it’s an excellent example of typical APRs, and will help to show you just how ludicrous payday loan APRs are.

As a third example (and then, I promise, I’ll show you some actual examples of payday loan APRs), let’s consider mortgage rate prices from January 2010 through to the end of October 2010. Over that period of 10 months, mortgage rates ranged from 5.21% to 4.19%. Keep that in mind as we move on.

It’s worth mentioned that car and mortgage loans are usually for large sums of money, so lenders can afford to charge a lower rate. They still make plenty of money. 4.19% of $200,000 is $8,380, and that’s before you take compounding into account. Not too bad for a few days work.

Some Actual Payday Loan APRs

How does 521% sound? That was the stated APR for a lady that I met with that was struggling with her debt. The was the highest rate she had, with the others all being above 300%. If you ask me, it sounds absolutely ridiculous. And that’s not even the highest it goes. Payday loan APRs can range from about 390% to 780%.

Did your jaw hit the floor yet? Well pick it up and make this promise to me and to yourself right now.

“I promise to NEVER get a payday loan. I promise to remember that there are other options, and to explore what they are before making drastic decisions about my finances.”

Trust me, they simply aren’t worth it.

We hear a lot about how Americans don’t save enough for the future, and how important it is to have an emergency fund for a rainy day. But we also hear a lot about the importance of getting out from under crushing credit card debt. So it’s only natural to wonder which is more important.

At first glance, you might think the answer is always “pay off debt first.” But there are a few things that you should consider before taking this advice.

1. Know Thy Enemy. Sometimes consumers do the wrong thing, for the right reasons. For example, given all the hair-raising news about eroding home equity and foreclosures, many consumers are pumping extra cash into paying off their home mortgage, rather than directing that money towards other more potentially dangerous debt like credit cards.

It is unwise to pay down your relatively low-interest, tax-deductible home mortgage, student loans, or business loans if you carry other more volatile forms of debt.

2. Break the Piggy Bank. As painful as it sounds, many times cashing in your low-interest savings account to pay off a high-interest credit card is the right choice.

Interest accruing in most savings accounts can’t keep pace with the interest accruing on a credit card account, so it is generally a wise move to raid the savings account to help get out of debt.

3. Divide and Conquer. When analyzing debt, carefully consider what motivates you the most towards repayment. Does paying interest drive you nuts? Perhaps paying off your highest interest rate card first make sense. Do you need some quick wins? Maybe you should pay off a couple low-balance cards early in your plan. However you decide to do it, figure out a way to single out one debt and make it your top priority.

Pay the minimums on your other cards until you slay the beast with the highest interest level, the highest emotional involvement (a personal loan to in-laws, for example), or the lowest balance (following the debt snowball method). Then move to the next worst offending debt and so on.

4. Know Thyself. There are two schools of thought regarding saving vs. paying off debt. One school of thought is that you should pay off the debt entirely before beginning a savings regimen. This works well until the bottom of your hot water heater gives way unexpectedly and you wind up with a hefty cleanup charge, which might lead to a credit card tailspin.

If you are the type of person who can stick with a payment plan, regardless of occasional setbacks, you should pay of your credit card debt first. If you are more likely to be derailed and disheartened by an unexpected expense, it might be wiser to focus on creating a rainy day fun, while committing to a cash-only plan for new purchases.

Once a small nest egg is built, then the attack on debt can be renewed with more confidence.

5. Hands off the Cookie Jar. In the rush to get out of debt, some people consider tapping into or liquidating their 401(k) or IRA funds. This is a poor personal finance move, since not only will you be gouged by Uncle Sam upon withdrawing the funds prematurely, you will also be losing the long-term impact of those funds on your overall financial well-being.

Some folks might stop short of cashing in their retirement funds, but instead decide to take a loan out against their 401(k). This can be a viable option for a disciplined borrower, but beware that failure to payback the loan from your 401(k) in a timely manner can result in weighty tax consequences and stiff penalties. Also keep in mind if you are laid off, or you decide to switch jobs, the loan may be due in full immediately.

For those tackling debt, how have you decided to go about it? Save first, pay off debt, or a little of both?

In a bad economy, con artists, scammers, and schemers come out in full force.  This time around is no different, with a number of profit-motivated credit counseling companies popping up and pushing “debt management plans” to consumers.

With so many Americans out of jobs and up to their eyeballs in debt, bankruptcies are at decade highs and many people are desperate to unburden themselves and start over.  So it’s easy to make debt management and debt relief sound like a good idea.  Who doesn’t want to shed their bad credit and move on with their lives? And while there is nothing inherently wrong with a debt management plan, it pays to be skeptical when anyone makes promises that seem to good to be true.

Over the past ten years or so, a new breed of credit counseling agencies has become common, with these agencies making unscrupulous promises on what they could negotiate on your behalf, and charging absurdly high upfront and ongoing fees. These companies spend heavily on TV advertising due to their hugely profitable businesses, causing additional headaches for already indebted families.

You’re probably seen many of these TV commercials or gotten unsolicited emails or phone calls advertising their “nonprofit debt relief services.”  And while you should definitely never sign on with a “for-profit” credit counselor, the nonprofit designation doesn’t necessarily mean you’re safe.  Many unscrupulous agencies designate themselves as 501(c)(3) organizations in order to falsely gain the trust of potential customers, and it doesn’t necessarily mean they aren’t motivated by their own bottom lines.

Fortunately, there’s help available

Just a few weeks ago, the FTC rolled out a new rule to protect consumers from just these types of debt relief schemes.  On October 27, 2010 they designated that credit counselors are not permitted to collect fees in advance of helping you with your debt.  It’s never been a good idea to pay these guys before they help you, but now the FTC has made it official.

Specifically, debt relief companies that sell their services over the telephone can only accept fees when the following criteria are all met:

• The company successfully helps to change the terms of at least one of the consumer’s debts
• The consumer and the creditor come to terms on a settlement agreement or debt management plan
• The consumer has made at least one payment under the agreement

What does this mean for consumers? The idea is to prevent debt relief rackets from making money off of high upfront fees, often with unrealistic promises of success. Prohibiting those fees means debt relief companies can only charge when they are at least partially successful, so they’re no longer likely to prey on clients they can’t really help. It also means we’re likely to see fewer misleading ads.

It still pays to be a skeptic

Another FTC rule took effect on September 27, 2010 that requires debt relief companies to make specific disclosures to consumers about the services they provide and prohibits them from making misrepresentations. Specifically this means they need to tell potential clients how much their services will cost, how long it will take them to see results, what could potentially go wrong, and what (if any) dedicated accounts will be set up to make creditor payments, collect fees, and so on.

That’s generally good news. But the new rule changes also mean that companies will look harder to find loopholes, as is common in any financial or debt-related industries. So regardless of any rules designed to help you, you should still always be skeptical. Before signing on with any such agency, do some research and verify that they have your best interests in mind.  One good place to start to do such research is the NFCC website, where you can find advice and information about legitimate credit counselors.

With the right help, it’s only a matter of time before you’re back on your feet and en route to rebuilding your credit history.

To answer that question, we must first consider the less obvious answer: some people don’t care. Seriously. They are apathetic, believing debt is just something people are supposed to have. After all, who can afford to buy a house or a car with cash, and even if they had enough, who would want to drop that much cash on such a large purchase?

Ignoring for a moment the side argument on whether or not it makes sense to pay cash for a home, I can understand how people have come to accept debt as normal.

Unfortunately, we live in a debt-driven society. We are told to get out and spend to resurrect our economy, even when we don’t have the money, or prefer to save it for a rainy day (and even when we see storm clouds gathering on the horizon).

A Debt-Driven Society

We are inundated with advertisements from credit card issuers, banks, car dealers and on and on. Our media is saturated with messages that make us feel inferior, or somehow inadequate, if we don’t own the latest gadget, a bigger house, a fancier car, nicer clothes, more bling, more toys and more payments (OK, so they don’t advertise that last one).

The only way to break yourself and your family free from the vicious cycle of debt is to finally scream ENOUGH! Enough of the marketing. Enough of the feelings of inadequacy. Enough of being compared to others. It is time to start living withing our means, not the couple down the street with two sports cars, a boat, a bigger house and a condo on the beach.

I have nothing against those people, but I am not in competition with them either, because financially, we have little in common. We have more mouths to feed. We make different choices. We make less money because my wife stays home with our children. We forgo the trappings of today for the promise of financial independence in the future. And that is just fine with us. But it hasn’t always been.

For far too long we tried to keep up with those people by augmenting our lifestyles with debt. It was all a facade, and the funny thing about it was people probably expected that we were simply using debt to finance a lifestyle that they could afford, but we couldn’t. Who were we fooling? Ourselves.

Then one day I woke up broke with a dead end job, a wife and two kids and nothing to show for seven years in my first career but a pile of debt and high blood pressure. We decided it was time to quit fooling ourselves, and to dedicate our lives to a more frugal existence. If you can’t first be honest with yourself, you can’t be honest with other people.

It’s difficult to admit to yourself you’ve screwed up. But this admission is very important, because continuing a lifestyle of financial denial only leads to a bigger hole to dig out of down the road. Like the saying goes, when you find yourself in a hole, stop digging.

STOP…

• paying minimum payments on your credit cards.

• writing balance transfer checks from one card to pay another (yes, I did it).

• getting cash advances from ATM machines because having a wallet filled with cash makes you feel rich.

• shredding bills without even opening them because you’d rather stick your head in the sand than face reality.

• reaching for your card to finance “emergencies,” sales and groceries. So many people rail against those dependent on the government, but are just as dependent on Visa and Mastercard. Don’t be a slave to big banks.

• opening credit card accounts for free t-shirts (been there), or 10 cents off a gallon of gas (done that), or some silly rewards program that accumulates points so you can exchange them for more crap to put next to the crap you’ve already stuffed inside your home using credit cards (done a lot of that!).

• turning to debt to finance cars because you lack the discipline to save cash for a car, or the discipline to buy a less sexier car. Cars do not define you.

START…

• finding ways to boost your income. Overtime, part time work, a side hustle, selling your crap all qualify as potential ways to get your income up. There is no shortcut to getting back to even.

• accepting responsibility for the actions that got you in debt. For years I blamed my employer, school, medical issues, lack of financial education growing up, etc. for my debt balance. How ridiculous. So many people have had it much worse, and managed to live within their means. So could we.

• educating yourself about personal finance. Much of what I’ve learned along the way I learned from reading. I checked out books at the library. I read magazines about money. I even watched and listened to media geared towards personal finance (radio shows, television shows, etc.). Turn off the football game, or the IQ-draining sitcom, and pick up a book about personal finances, or budgeting, or investing, or mutual funds, or insurance, or maybe even a biography about someone whose financial situation you admire.

• thinking about ways to get money working for you, rather than the other way around. How much better would your financial life look without debt? Create a dream budget and replace your debt payments with contributions to savings accounts, college savings funds, and your retirement account. Replace interest payments with interest income. Figure out just how much being a slave to debt is really costing you.

• reducing your monthly expenses to free up income to put towards debt repayment. Cancel the cable. Stop eating out. Shop your car insurance. Cut your own hair. Bicycle to or from work. Get radical.

So, You Want to Be Free?

Leading up to last week’s election a popular theme was personal and economic freedom. Some people think government is infringing on our freedoms. Others think government isn’t doing enough.

I say many in both groups are forgetting that they have already given up their freedom. They are totally dependent on banks to finance their emergencies, their businesses, and their households. They willingly sign away future paychecks in exchange for borrowed money.

Businesses turn to banks when they can’t make payroll. People ask for loans to pay off other loans, or loans to finance their education, or loans to finance an emergency car purchase because their other one just died. They often find themselves begging someone thousands of miles away in a call center for credit limit increases to finance emergency travels to care for a love one.

So if you really value freedom, you will join me in first ridding yourself of the bondage of debt. When you sign up for a loan, you are at the mercy of the bank and its well-crafted fine print filled with legalese and the many ways they can control you for the life of that loan. And if you don’t play by their rules, remember they have your credit held hostage, and they don’t mind reporting to the credit bureaus the first time you slip up.

The next time you have an emergency, you can still call the bank, but this time it will be to move a little money from your emergency fund to your checking account to cover the plumber’s bill, or the hospital, or from your business emergency fund to cover repairs on the company truck. No longer will you be at the mercy of those holding the credit. Now, you are truly free.