Answer to Gail’s Polly Riddle

Doing this in a post because I couldn’t fit it all in the Comments section and this was a lot of fun!

Gail Vaz-Oxlade from Gail’s Blog gives us a Case Study:

Polly is 25 and single. She has almost $80,000 in debt, $60,000 of which is student loans. The rest is credit card debt. Polly makes $40,000 gross a year working full time, and she has a part time job where she grosses another $10,000. She has no savings and no emergency fund.

She’s about to get a $5,000.00 tax refund, which she is planning on using to pay off 2 credit cards and start an emergency fund of $3,000.

Polly can’t decide what to pay off next. She has contacted her credit card companies and cannot get her interest rate lowered nor does she qualify for a debt consolidation loan. She’s currently spending 15% of her income on debt repayment.

Read the rest here: Polly Case Study from Gail Vaz-Oxlade.

My Answer

What should she have done before?

If she’s 25 with almost $80,000 in debt with $60,000 of it being student loans, that means that assuming she went to school for 4 years for a Bachelor’s Degree, she spent $15,000 each year (roughly), and $20,000 in consumer debt means she must have made up the difference of any shortfall she had in the 4 years using credit cards for living and entertainment expenses.

She must have gone over budget by $5000 each year or $416.66 each month to cover her living expenses, assuming again, no part-time job and no savings prior to starting university, which means she spent around $1666.66 each month on expenses which sounds reasonable for a student if you assume roommates and ramen with some heavy drinking which seems to be the staple of every student.

What she should’ve done during school was done a budget, tracked her expenses and figured out if she needed to get a part-time job (assuming she didn’t have one), so that she didn’t have to resort to using credit cards to live.

If she cleared the balance on her cards each month, she could have also paid for her expenses on a credit card that gave her grocery points to use towards lowering her food bill like PC Financial but I am assuming she wasn’t good with credit cards to have cleared the balance each month. Every little bit counts especially with grocery points from PC because you can buy toiletries and food with the points.

During school, they also offer bursaries or scholarships – she should have (or may have) tried for those. They give them to students in need.

Another thing they offer is those co-op positions that pay around $12/hour and give you a set 12 hours a week to help out on campus.

That’s a good wage, and a good amount of hours that it would not affect your studies. 12 hours x $12 = $144/week or $576 a month, which would have MORE than covered the deficit she racked up during school using credit cards, and given her a balance of $159.34 she could have put towards her Emergency Fund and/or Savings.

If she did that for 4 years, she could have had $7648.32 as her Savings/Emergency Fund before starting her job.

That’s also not to mention the free summers she had (assuming she didn’t take summer classes). She could’ve picked up a full-time job and saved money during that time to help her during the school year when she cuts back on her hours to concentrate on schooling, and she (like me) could have worked those co-op hours during the summer, and taken another part-time or full-time job on top of that to make even more money, since $12/hour is a good wage versus the minimum wage you get in retail.

Hard to say. I’d have to have more information on her 4 years, but that’s what I gleaned out of that so far.

Clear the highest interest credit card first

Polly should clear her credit card of $6500 at 18.5% interest because it’s the highest of the bunch, and happily, also the lowest balance which will give her a motivational push to continue with her debt reduction.

Then she can take that amount she had put towards the $6500 and put it towards the next highest interest rate (the second credit card).

What does she earn now, net?

She earns $50,000 gross which means assuming she lives in Ontario, the take home pay net is $40,158.

Which means each month she brings home $3346.50.

Assuming prime is 5%, then based on the numbers above for credit cards, she pays $525.21 in interest (no principal in that amount) each month which is 15.69% of her net income, which is actually over what she is paying each month towards debt (15%), by 0.69% or $23.09.

A small amount, but that adds up.

Her debt service ratio and my notes

Her current debt service ratio is 15% as mentioned but should be higher because it only covers interest and not the principal from my calculations, but no higher than 30% should go towards debt repayment, and even that might be a bit high in some circumstances.

She must not be paying the full interest and just the minimum payments on some credit cards because I am assuming she must also be on a fixed plan with those government student loans if her grace period has ended which I am assuming it has because she’s 25 and she must have graduated at around 24. Grace periods are normally 6 months with the Ontario government, and 6 months to 1 year with a line of credit.

She should be paying a maximum of $1003.95/month towards debt if she wants some of those payments to go towards clearing the principal and not just in the interest.

To get out of the hole, she now needs to do the following:

Note

If she pays the maximum of $1003.95 towards debt each month, that leaves her with:

$2342.55 each month for living expenses

$334.65 of which should go into savings for now

Which will leave her with $2007.90 to cover rent, groceries, entertainment, transportation and other.

Here’s my rough budget I mocked up for her based on my assumptions from above.

Things she can do to get out of debt

1. Keep that $3000 Emergency Fund in a high interest savings account to only be dipped into if it is a real dire emergency (not that she wants new shoes for fun). She should NEVER use the $3000 to pay down her debt because if an emergency comes up, she could be in big trouble and have to resort to using credit cards again.

2. Create a budget with NET INCOME in mind, not Gross Income and keep track of all her expenses and sum them up each month against her Budget.

3. Consider looking for a credit card with low interest rate if she does a Balance Transfer. She could do that with her $6500 credit card and save at least 15% in interest! (Assuming most balance transfers are around 3% as the offer rate).

4. Save at least 10% of her income $334.65 and put it into the TFISA (Tax Free Savings Account), each month which will equal $4015.80 which is just under the $5000 maximum limit for that year. Let the compounding interest do its magic!

5. If she has a company match, she should contribute to that to the fullest percentage to take advantage of ‘free money’, which comes out of her $334.65 budget each month for saving.

6. Cut back, way back on entertainment and eating out and other expenses. I don’t know what she spends now, but neither does she from the sounds of it so she needs some background on her spending habits from the past 6 months to really make an accurate budget.

7. Learn how to cook if she doesn’t already. She can entertain at home, so learning how to cook will be handy. She could bring lunches to work and invite people over for dinner instead of going out. It saves a hell of a lot of money each year as I found out 3 years ago.

8. Try and find a place with lower rent because she may be paying too much rent if it’s over 30% of her net income ($1003.95). Now is not the time to be fancy with apartments. Get a roommate or find a bachelor’s pad that’s close to a subway station or bus stop so that she can still get around.

I am also assuming she doesn’t have a car, or that it’s fully paid off and she just has to pay for the gas and maintenance.

If she doesn’t have a car, keep it that way if she can. I saved a lot of money in insurance, gas and maintenance by not even having a car for the first 25 years of my life. It sucked, but it helped.

9. See whether she can make more money than $50,000 (maybe her $10,000 part time job could offer her more hours to bump it up some). She could also do chores here and there for $100 each, by asking neighbours what needs to be done.

10. Sell what she has if she has a lot of junk lying around with tags on or unused (it’s what I did to help myself get out of debt, and every little bit counts).

11. The student loans could be paid off after the credit card debt because it’s at a lower interest rate than 18.5% or 11.5%, and the interest on the government student loans (seeing as one may be from the government since it’s a loan at 6% and the other is a line of credit), is tax deductible, which will help, even if just a little bit.

12. Stay on a cash budget only with the information above (unless she can really prove to be disciplined to use a credit card like PC Financial to get grocery points to earn free points towards groceries like I did during school).

The way I’d budget is bi-weekly because I’m assuming she is paid bi-weekly.

Take the first paycheque, allocate that towards your hard expenses (rent etc) and then towards variable (groceries). The second paycheque is for ‘fluffier’ things like entertainment because it’s in the second half of the month.

Any remaining money should be put either into savings or into debt repayment. I’d choose the latter.

Phew!! This was fun!!!! 🙂 (Yes, I’m a geek.)