A Family’s Plan to Become Debt Free

The Problem/Goal

Maria and Joseph Martinez are married and have a daughter, Isabella. Up to this time, they have enjoyed a very comfortable middle-class lifestyle, as both Maria and Joseph are well paid professionals. Unfortunately, due to the economic crisis, Maria has recently become unemployed and has reached out for help in budgeting for the current situation and re-adjustment after becoming re-employed. As Joseph was working out of state, all communications were with Maria.

“I have never had a break in employment in 22 years,” said Maria. “It is really unusual to be unemployed, almost surreal, but the realization that hits home is that being unemployed is like being in prison.”

Although her unemployment has not caused any drastic lifestyle changes thus far, Maria is aware that they have not prepared for emergencies or long-term goals. She now wishes to incorporate recovery with planning for the future. 

For Maria and Joseph, a major hurdle to becoming financially secure is a large debt burden, including credit cards, car loans and a student loan, all of which carry an average of more than 10 percent interest rate. When asked about goals, Maria was very clear on what they desired, and also clear that she hasn’t been taking the actions necessary to accomplish them.

Summary of Goals

• Providing a good college education for Isabella.
• Building some sort of net worth.
• Feeling financially secure post-retirement.
• Clearing out the mountain of debt and never getting so far extended again.
• Leaving an inheritance for their daughter.
• Having more equity in their home.

We asked a team of students from FPA of Virginia Commonwealth University to analyze Maria and Joseph’s situation and recommend a plan to reach their goals. 

The Solution

Financial planning is an ongoing process, during which new information and life events often change the course of your plan. The discussions that follow are based on Maria and Joseph’s lives today, and the information that they provided. Some of the recommendations will be very specific, others more vague. This approach is based on the assumed evolution of their personal and financial situations.

Data Gathering & Assumptions

From a planner's side of the desk, it's important to start at the beginning. Financial planners and clients mutually define a client's personal and financial goals, needs and priorities. The next step is what financial planners call data gathering — financial planners obtain all the quantitative information and documents about a client before any recommendation is made and/or implemented.

Maria eventually found a new job. As such, reasonable assumptions about changes in cash flow due to the new job were factored in the recommendation. As the new job appeared in the middle of the analysis, all work was done on the new cash flow. Information provided included:

• Maria is in her early 40’s, Joseph has just entered his 60’s and Isabella is nine.
• Joseph averages $200,000 per year as a consultant.
• In her previous job, Maria earned $130,000. After a period of unemployment, she became re-employed and now earns $72,000.
• Current cash flow (out) is approximately $150,700 per year plus taxes and business expenses (approx $260,000).
• Liquid assets total $58,000 ($24,000 in a 529 plan).
• Residence value is $389,000.
• Liabilities total $527,030
• Student Loan: $74,000
• Car loans: $24,500
• Mortgage: $368,000 (approximate value of home)
• Credit Counseling group: $43,000
• Retained credit cards: $17,530
• Net Worth: 447,700 – $527,030 = - $79,330.
  

Assumptions were made regarding decreases in health care costs with the new employer plan, increases in child care, clothing, transportation and various household costs related to re-entering the work force. Known cash flow was used in the recommendations with only minor spending assumptions. Debt management appears to be the most critical aspect of the case, so it was addressed first.

Debt Management Plan

Although there appears to be little equity in the family residence, the existing mortgage is held at a rate of 4.24 percent. It is recommended that Maria and Joseph use this asset at a favorable rate and continue it in its current status.

One car is for Joseph’s business use and has a deductible payment of $450 per month. This is viewed as reasonable. Maria’s BMW has two more years of payments of $1,175 per month. It appears that it would be difficult to liquidate the vehicle at this time. So it is recommended that it be retained after the loan is paid and that the payment be added to current cash flow as a resource for regaining control over consumer debt.

The student loan is large and carries an interest rate of 7.75 percent, but compared to the rate on the consumer debt, it is relatively inexpensive; therefore, it is recommended to apply for forbearance while retiring the consumer debt. The Consumer Credit Counseling debt has a balance of $43,000. It is a serious consideration, but the retained debt carries a higher interest rate debt and should be addressed first. Even though the main justification for forbearance may have passed (unemployment), the recommended schedule for payment does not include relief of the student loan.

Joseph and Maria decided that several credit cards should not be turned over to Consumer Credit Counseling as they were used in their daily lives. With the exception of a $16,000 debt on a credit card used for business purposes, this retained the debt totals only $1,530 and yet consumes $350 per month in cash flow. If they add only $150 per month to their current payments, and do not add further purchases to these cards, they can all be paid off in only four months, freeing that $350 for other purposes. Of course, they should pay the highest interest rate cards first.

Next, we suggested they turn their attention to the American Express balance for a suggested payment of $1,200 per month. As a result, it would take 16 months to pay off the $16,000 credit card balance. 

At this point, the car loan has only four months of payments remaining. Once the BMW is paid, an additional $1,175 per month is available for debt reduction purposes. The new total to be applied to outstanding debt, without impacting their lifestyle, is $2,375 per month ($350 from old consumer payments, $150 from free cash flow derived from re-employment, $700 per month from American Express card, and $1,175 from the car payment). The Consumer Credit Counseling debt has been reduced from $43,000 to $25,000 from the $1,099 payments during this period. By applying all of the newly created cash flow to this one last bill, it will be paid off in less than one year. 

In only three years, Maria and Joseph can go from a helpless cash flow to having $41,688 free cash flow per year. Also, their net worth will go from negative $79,330 to a positive $69,000 due to debt reduction — a swing of almost $150,000 in only three years with no impact on their standard of living. This will take dedication on their part to avoid charging anything that cannot be paid off in the same month and continuing with the debt reduction plan outlined above. 

During the previous three years, the $74,000 student loan debt has been reduced to $65,000 with the regular $700 per month payment. If we apply the entire $3,474 of free cash flow plus the $700 regular payment to this debt, then it will be retired in less than two years.

Long-term Goals

Education Funding

In addition to the current balance of $24,000 in 529 plans, Maria and Joseph are saving $200 per month. By projecting forward their current rate of savings and the likely cost of a public university, we find that by increasing the amount to only $250 per month, a four-year college education can be comfortably paid for. This leaves open the option to provide additional funding from the comfortable cash flow if a more expensive institution is desired.

Net Worth & Retirement

It is now time to incorporate all the improvements to the cash flow with a little help from the US Government. Five years have passed and Maria and Joseph are in a comfortable position with approximately $50,000 free cash flow in their budget. Joseph has now reached the age where he can begin collecting Social Security retirement income with no offset due to earned income. This amount should be in excess of $25,000 per year, so let’s use that number. We are now looking at approximately $75,000 available for the remaining goals. 

College and debt are now very much under control. Building net worth, funding for retirement and leaving an inheritance for Isabella are the remaining goals, and they can all be tied to increasing their net worth. Remember the $75,000 per year? Let’s put it to work!

Let’s assume that Joseph is willing and able to work another five years. Let’s also assume there is a modest return on investments of 6.5 percent. The liquid assets of $58,000 in 2011 may now have grown to around $80,000. By adding $75,000 per year over the next five years, that total may swell to more than $536,630. If Joseph decides to retire then (he may also decide to continue as a part-time consultant), they would still retain the ability to save a modest amount. Even without savings, Maria will probably continue working at least 10 more years after Joseph retires. That would allow their investments to grow to more than $1,000,000. Not a fortune in the world of 2031, but significantly better than their current situation. 

If Maria is willing to place the balance of excess cash flow from her new employment into a 401(k) plan (let’s assume $350 per month with a 50 percent match of $175) there would be another $271,000 available, for a total of almost $1.3 million. By now their mortgage may be paid and that would allow them to reduce their cost of living significantly. So with Social Security for both and a 4.5 percent withdrawal rate on investments, they could be looking at a retirement cash flow stream of almost $130,000 per year without counting any excess proceeds from the family home. That would be the equivalent of more than $70,000 in today’s dollars.¹ Without the mortgage or the expenses of a child living at home, and with the addition of Social Security, it could very well provide a comfortable living.

Asset Protection

Below are several suggestions for Maria and Joseph to keep in mind as the future unfolds:

Homeowners Insurance: This is currently a part of their mortgage payment, but that should not stop them from comparison shopping from either their State Corporations Commission or an Independent Insurance Agent. They should find out how many companies provide homeowners insurance in their area and pay special attention to any that are mutual companies, as their pricing is frequently beneficial. They should be sure to compare policies with identical benefits, and that the insurance amount is adequate to rebuild their home in case of a catastrophic event.

Automobile Insurance: In many areas of the country, the variance in automobile policies is an amazing 300 percent, so it pays to shop for insurance on a regular basis. Also, they should be sure to have Joseph’s car covered with a business use addendum.

Liability Insurance: There are two forms of this insurance to be concerned with. First, would be a general liability policy for Joseph’s business. Second, would be an umbrella policy for the family. Although they may seem to be insuring the same issue twice, it is important to note that business coverage needs to be separated from a general policy for the family, the same as for the automobile policy referenced above.

Life Insurance: Maria now has employer-paid life insurance and Joseph has a personal policy. They should be sure to keep those in place until retirement as a premature death in the meantime would destroy the assumptions used for projections in this report. They may also want to consider consulting with a insurance specialist to ascertain what level of insurance would be necessary in a survivor situation to ensure that their coverage is adequate.

Disability Income Insurance: It is not apparent whether Joseph carries this insurance. If not, it would be most advisable to obtain it. Maria is likely to have disability insurance as part of the benefits package with her new job, so she should read her human resources manual to determine both the coverage amount and duration of coverage.² If it appears weak, there are individual policies available for a small portion of income and a Social Benefits Rider which provides underlying coverage for the majority of income.

Health Insurance: This was a large expense during unemployment as Maria’s work coverage covered all three family members. Although we don’t know the employee contribution of the new coverage, it is estimated that $450 per month is the average for comprehensive employer coverage for a family. Under the new laws, this will provide protection for the family until Isabella is 26. When Joseph turns 65, they will need to do a quick analysis of moving him entirely to Medicare and keeping the employer’s coverage only on Maria and Isabella vs. maintaining the entire family on one policy.

The Summary

The previous offers a road-map as to how this family with a recent income/debt crisis could completely remodel their financial future without sacrificing their current standard of living. With additional counseling and dedication on their part, the outcome could be even more appealing. But sacrifice is a subject that needs a great deal of discussion and commitment. 

Maria and Joseph took many years to create the financial situation they found themselves in, and as shown, it will take several more years to prepare for a secure future. Simply going back to their old consumption patterns would make the illustrated scenario impossible to achieve, so it is hoped that they will see the benefits of being debt free and be able to build a substantial net worth for the future. All the raw materials are in place, and the required behaviors have been outlined, so it is entirely up to them as to what future they create for themselves and their daughter.