Upon graduation from Cornell long ago, my net worth consisted of a $1,000 loan from my parents, juxtaposed against college loans and credit card debt. I was failing one of the first tests we have as independent adults: a financial stress test. Not only was I living beyond my economic means, but I also had no way of surviving an economic shock: getting sick, losing a job, or even repairing a car. And the "stress" part was no picnic either.
Can you pass a stress test? Are you able to keep your standard of living after a layoff, a large medical bill, or a losing investment? Does financial worry keep you up at night?
The best ways to pass a stress test are to reduce debt, and to increase available assets. In this post, I will give you specific ideas on which kinds of debt to reduce, and how. Next week, I will teach you ways to shore up your assets in case of emergency.
Debt is appropriate when you're borrowing against an appreciating asset, one that increases in value over time. Homes grow in value over the long term, and therefore mortgages are an appropriate debt. Business ventures (assuming you've done your homework, you're competent, you work hard, and you're lucky) are appropriate. Even college and graduate education is appropriate, as an education historically more than pays for itself over time via higher income and professional growth potential.
What's inappropriate debt? The classic example is credit cards: these almost always indicate that you're living above your means, and should only be used as loans in cases of emergency.
So, one element of passing your financial stress test is eliminating your inappropriate debt. Focus on this debt first, and you strengthen your ability to pass other parts of the test.
So, how to pay off this debt? If you have credit card debt, remove all your cards but one from your purse or wallet, and stick them in the freezer ... ideally in the back. Take your one remaining card (Mastercard or Visa only), call the bank of issuance, and request that your credit limit be lowered to $500 above your current balance. Take this card, and bury it somewhere out of sight in your car. (I suggest taping it to the underside of the passenger seat.) This gives you enough credit for an emergency in case you're stranded somewhere, but not enough for a shopping spree.
Next, write down the amount you owe, and the interest rate charged, on each card. Tape this list to your bed, fridge, or wherever you'll see it most often. Every month, pay the minimum for each card, except for the one with the highest interest. For that card, pay off the most you can possibly afford. Then, update your list of card debt to reflect your payment. This should help motivate you to repeat this process every month.
For most people, the hardest part of this exercise is cutting back on fun stuff: restaurant meals, shopping excursions, even gourmet coffee. So, when you pay off a credit card, give yourself a small reward: go out for a nice dinner, or give yourself some other treat. Just don't use a credit card to do it!
By paying off this inappropriate debt, your net worth goes up, you have hundreds of extra dollars a month to save, and most importantly, you're that much closer to passing your financial stress test. Stay tuned for tips to increase savings, coming next week.
Lou Dagen is a Certified Financial Planner in the San Francisco Bay Area. For 23 years, he has helped clients around the world retire in comfort, educate their children, and increase their net worth. If you have questions, please post them in the comments below or call Lou directly at 925-997-8507.