If you’re wondering how to become debt free on a low income, we’ve got a game plan for you. It is possible to get out from under a high debt with a little hard work and budgeting.
Jenny and Aaron currently owe $26,000. Today I’m covering their budget and showing them how they can be debt free in 18 months thanks to a debt snowball, work bonuses, and tax refunds.
Here’s Their Budget for Debt Paydown
This budget is based on two $1,350 paychecks per month. Health insurance and retirement contributions are withheld from paychecks, so don’t appear in the budget. 401k loan payments are also withheld from paychecks.
You’ll notice a lot of $0 categories. That’s a reflection of the change in lifestyle Jenny and Aaron will experience by committing to getting out of debt. Paying off the balances will allow them to start funding those categories again.
Jenny tells me Aaron’s annual work bonuses are very consistent (he works for a very large, growing company whose commercials you see every day). Although they’re expecting a raise before year-end, it won’t be huge and their tax refunds should be close to what they’ve been in the past.
It’s also worth noting that this snowball doesn’t include the two “extra” paychecks per year Aaron gets (because he’s paid bi-weekly), and it also leaves out the raise I just mentioned (which has already been approved).
How to Pay off The Debt: The Plan
As long as Jenny and Aaron live within their means, they can be debt free in a very reasonable amount of time. The snowball kicks off using $5,000 from the savings they’ve set aside for their two kids’ future. Although it’s emotional, they agree that they need to solidify their own finances before they can hope to help their kids.
Here’s the plan:
1. Use Savings to Pay off Credit Cards
They’ll pull from their savings to pay off Credit Cards 1 and 2 completely.
($500 + $3,050 = $3,550)
2. Use Savings to Pay Down Final Credit Card
Take another $1,450 from savings and, combined with payments from Credit Cards 1, 2, and 3, pay down as much of Credit Card 3 as possible.
($1,450 + $140 + $100 + $100 = $1,790)
3. Focus on Final Credit Card
This leaves Credit Card 3 with a balance of around $2,650. Make payments of $340 per month (combined payments from Credit Cards 1, 2, 3) from October to January (4 payments). Allowing for some interest, this drops the balance on CC 3 to ~$1,500.
4. Use Work Bonus to Pay Off Final Credit Card
In February, use first portion of annual work bonus ($1,500) to pay off Credit Card 3.
5. Use Work Bonus+Snowball for Car Loan
Combine remaining portion of work bonus with snowball payment ($340) and normal car payment ($235), and throw it all at the car loan. ($1,500 + $340 + $235 = $2,075). Because you’ll have made four more car payments between now and then, the car loan balance should be around $8,500, and the $2,075 payment will drop it to around $6,400.
6. Use Tax Refund for Car Loan
Put your entire tax refund toward the car loan. If you get your taxes done quickly and get the refund in February, that drops your car loan balance to $1,400.
($6,400 – $5,000 = $1,400)
7. Use the Snowball to Pay Off Car Loan
Using your new $575 snowball payment ($340 from paying off credit cards + $235 from car payment), your car loan will be paid off in three months. Which means credit cards and car will be paid off in May of 2014.
8. Use the Snowball to Pay Off 401k Loan 1
Apply the whole snowball to 401k Loan 1. You’ll pay it off in around four months. ($575 x 4 = $2,300). The loan will be gone around September of 2014.
9. Use the Snowball to Pay Off 401k Loan 2
Combine the monthly payment from 401k Loans 1 and 2 with your snowball payment and apply the entire amount to 401k Loan 2 for the four months between October 2014 and January 2015.
($6,500 loan – 4 x $650 = $3,900 remaining on 401k Loan 2)
10. Use Work Bonus + Tax Refund to Pay off 401k Loan 2
Use $3,000 from 2015 work bonus and first $900 of 2015 tax refund to pay off remainder of 401k Loan 2.
11. You’re Debt Free!
That’s it! Game over! You win!
Fight For Your Goals
Jenny and Aaron – it’s going to be tight, but you can do it. Getting out of debt involves one big decision (“We’re through borrowing and we’ll do everything in our power to get out of debt.”) followed by small, daily decisions (“We’ll buy that DVD when we’re out of debt.”).
Work together and fight for your goals. When the snowball is done rolling, you’ll have freed up $600 per month – over 20% of your current take-home income, not to mention your annual bonus and any tax refunds. Life will be brilliant with no debt. Make it happen!
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