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How this couple paid off $45,000 of debt in 17 months, even after making 'a lot of mistakes'
CNBC Select spoke with a mother of 3 about how she paid off her debt after she cashed out a 401(k) loan to remodel a house and used a credit card to pay thousands in taxes to the IRS.
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In 2013, Ashley Patrick and her husband took out a $25,000 loan from a 401(k) to remodel their house, thinking they had years to pay it back.
But when her husband was laid off unexpectedly less than a year later, they couldn't afford to return the loan and had to cash it out. When tax season came around, they owed over $6,000 in early withdrawal penalties and taxes. They didn't have the cash to cover that bill, and so they made the hard to decision to pay their taxes with a credit card — something not many financial experts recommend.
Seven years later, Patrick, now a financial coach and author of the blog Budgets Made Easy, admits she's learned a lot since that huge tax payment. And the couple is now debt-free except for their mortgage.
CNBC Select spoke with Patrick to learn how she and her husband rebuilt their financial lives after a sudden job layoff. She shares why they now feel more prepared for the future, and what they learned from paying off their five-figure debt.
The 'safest kind' of loan
One of the biggest lessons Patrick and her husband learned was that taking out a 401(k) loan wasn't the best way to finance home renovations, despite the advice they got from friends.
"People told us that a 401(k) loan was the best option because you can pay it back over time, and it comes with a lower interest rate. We had just bought our house and didn't have a lot of equity in it, so a home equity loan was out of the question," Patrick tells CNBC Select.
At the time, they were planning to grow their family, so they moved into a nice-sized home with most of the amenities they were looking for. But they wanted to complete a few additional renovations to make it "just right."
In early 2013, they took out a $25,000 loan against her husband's 401(k). Patrick recalls logging into their retirement account afterwards and the feeling that hit her when she saw the new balance.
"I didn't understand that when you do a 401(k) loan, they take the money out of your account. I just thought that they would be using the 401(k) as collateral, but they actually pull out the money." This came at a huge opportunity cost, since they would no longer be earning a return on that money.
A new family member and a sudden layoff
In January 2014, six months after the birth of their second child, Patrick's husband was laid off from his job. He got a small severance, but since he was no longer with the company, his 401(k) loan was considered an "early withdrawal" with the IRS if it wasn't paid back in 60 days.
"But the money was already spent," Patrick says. "I was working as a detective at the time, and I didn't make a lot. My salary couldn't even pay our basic expenses let alone the $25,000 loan."
For all of 2014, the couple focused on finding work and getting by despite the unexpected loss of income. While they juggled these new responsibilities and welcomed their third child, Patrick says they forgot they would have to claim the $25,000 worth of income on their 2014 taxes.
They ended up with a tax bill of more than $6,000. "We used some of our savings," says Patrick. "But we didn't want to use all of it since we had learned the year before how important it is to have money put aside."
Taking advantage of a 0% APR promotional offer
The only way the couple could reasonably pay their tax bill is if they could set up an installment plan. Patrick says they looked into opening a 0% intro APR credit card, but instead went with a promotional offer that came in the mail from her existing Bank of America® Cash Rewards credit card. (The regular APR for the Bank of America Cash Rewards credit card is 12.99% to 22.99% variable.)
The promotion offered 18 months of no interest, and it came with a blank convenience check that Patrick could fill out and use as payment however she wanted. Depending on your card issuer, these blank checks are considered to be either a balance transfer or a cash advance, and even though it awards an intro period of 0% interest, there is usually a balance transfer fee of about 2% to 5%.
If you're looking to consolidate debt, but you don't want to pay a balance transfer fee, there are cards with no balance transfer fee, such as the Choice Rewards World Mastercard®.
Patrick doesn't remember the exact fee, but the Bank of America Cash Rewards card currently charges 3% or $10 (whichever is greater) for both balance transfers and cash advances. In her case, this would have added about $195 to her total balance. She maxed out her credit limit at $6,000 and dipped into the family's emergency savings to cover the rest of her tax bill.
Once Patrick filled out the check and sent it as payment to the IRS, she saw the $6,000 reflected on her credit card bill.
Budgeting for debt payoff
The next month, Patrick got a bill for $60, the minimum payment on her credit card account, and she recalls being taken by surprise when it arrived.
"I thought I had 18 months," she says. "I wasn't expecting to have to make a payment right away."
While the minimum payment wasn't a staggering amount, it made Patrick and her husband face the fact that they had no true plan for getting out of debt. Realizing this made something "click," says Patrick, and it motivated them to switch from survival mode into planning mode.
With a little research, they discovered the snowball debt repayment strategy and decided to pay off their debt balance by balance, starting with the smallest one. Proponents of the snowball method say that paying off the smallest balance first is one of the best ways to stay motivated.
The couple devised a plan: They would first pay off the $6,000 credit card bill, then move on to their $14,000 car loan and finally tackle Patrick's remaining student loan debt of $25,000.
Finding 'wiggle room' in the budget
Before they could aggressively pay off their debt, Patrick and her husband had to find room in the budget.
"The first thing we did was track expenses and that was so, so eye opening," she says.
The couple realized they were spending $1,200 per month on groceries and dining out. With some planning, they cut their food bill down to $600 and used the rest of that money toward their debt. This motivated them to find other areas to save.
At first, Patrick tracked their expenses by writing everything by hand: "I like writing stuff down, so in the beginning I wrote it out, but as I moved through the journey, I started using a spreadsheet so that I could play around with the numbers," she says.
The spreadsheet allowed her to see how much faster they could pay off debt if they paid a little more each month, or if there were any extra places they could trim spending.
If you've hit a wall and don't think you can cut back any more expenses, Patrick recommends calling your cable company and asking them to lower your payments or switch you to a different package. You can do the same with your cell phone provider.
Patrick and her husband also decided to drop their retirement contributions down to 3% while they were paying off their debt. This was enough to take advantage of her husband's company's match, but it freed up extra cash to put toward lowering their balances so they could save on interest.
Why the snowball method worked for Ashley
While there are a few different strategies for paying off debt, Patrick and her husband found they liked the snowball method best because they were motivated by their small wins. They paid off $45,000 in debt in 17 months.
"After we got the credit card debt done in three months, we looked at each other and said, 'We can do this!' The car loan only took four months to knock out. Then came the huge student loan, which took 10 months to pay off."
Patrick also stayed motivated when she calculated how much interest she was paying. Her student loan servicer, Nelnet, broke down her monthly payments to show how much went toward interest and how much was applied to lowering the balance.
"My interest was over 6%, so it was a lot," Patrick says. "I had borrowed $28,000 and had been paying the minimum for 10 years, but I only paid something like $3,000 on the principal."
Building up your savings account first
As our economy shifts, and we head into a period of widespread financial uncertainty, Patrick thinks we should all reevaluate the common advice that you only need a $1,000 emergency fund before you start an aggressive debt payoff program.
"I've learned that unemployment, or even a severance package, is not always going to pay your bills," Patrick says.
Now, she and her husband have at least six months' worth of expenses saved up, and they feel prepared for the future even amid news of a looming economic crisis.
"We made a lot of mistakes," she says. "But it started us down the path to being where we are now. We are in a much better place financially because of what happened."
The peace of mind, she says, is crucial. "Especially now that everything else is going on in the world. I'm stressed about a lot of things but not about money."
Information about the Bank of America® Cash Rewards has been collected independently by Select and has not been reviewed or provided by the issuer of the card prior to publication.