It happens to everyone: a monetary emergency happens, such as a car breakdown, draining your bank account. Bills are still coming in, and you know that you will not have enough money to pay for your debt obligations this month.
One of the first goals when developing a strong personal financial plan involves avoiding these scenarios by having a savings cushion, but this is not always possible. How can you get out of this situation with the least pain?
For the examples in this article, we will assume that you have enough groceries for the month, you have $1000 in your checking account, and your next paycheck is a month away. You just received all of your bills today:
|Bill Amount||Late Fee||Late Interest (Monthly)|
The total of all these bills is $1630 – way above what you can afford. Instead of getting worried or depressed, develop a plan of action.
Evaluate the Damage
The first step is to take a look at what will happen for each of these bills if they are not paid. This is a good way to prioritize which bills to tackle first.
- If your rent is unpaid for one month, you will get charged a late fee, but you probably won’t be evicted.
- Utilities usually cannot be turned off unless there are several months in a row of failed payments.
- Your internet connection probably will take a month or two of failed payments before your service provider shuts it off.
- If your cell phone bill is unpaid, your provider most likely will shut off your phone within a few days.
- Missing a credit card payment will not automatically put you in default, but you have a high interest rate and a late fee to deal with. Plus missing a credit card payment can really hurt your credit. This also applies to your car loan.
- Missing your student loan payment can put you in default fairly quickly. This is the stickiest kind of debt. Not even bankruptcy will remove it.
- Missing a payment on your car insurance might void your policy. And if you lose your insurance, you can no longer legally drive to work.
- Missing your health insurance payments might also void your policy, although there are some protections against this, and getting back on the plan might be expensive.
By knowing those facts about your different bills, now we can make a “ranking” of how important it is to keep each one of your creditors happy in the short term:
|High priority — must pay||Would like to pay||Can wait if needed|
This priority will shift a lot if you are facing multiple months of being behind on your bills. For example, if you are under direct threat of eviction, rent might jump near the top of the list.
Explore Your Options
Next, spend a few minutes to think about any other ways you can scrounge up enough cash to make all your payments this month. We discuss this in detail in our article on Short-Term Financing.
Borrow from Friends or Family
Borrowing money from friends or family members might be able to help bridge the gap. This is usually the cheapest and easiest way to get money to pay your bills, but many people are uncomfortable or unable to borrow money from the people they know.
Credit Card Financing
One option is to pay off your credit card first and then use the line of credit available to pay off all your other debts. You could then pay off the credit card balance with your next paycheck. This is the second fastest and easiest method. This will keep all of your creditors happy, and you will not accumulate much interest before your next paycheck, making this the least expensive option available.
Short-Term Unsecured Loans
A short-term unsecured loan is the type of loan you can ask for at a bank. Whether it is granted or not depends on your credit history, the amount you need to borrow, and the policies of the bank itself. If your bank offers you a loan, this is another workable solution. (This is NOT a payday loan. See our article on Short-Term Financing to tell the difference.)
Divide Your Paycheck
In the real world, dividing your paycheck is the most common course of action if the first 3 options fail. Some of your bills are completely non-negotiable and will cause major problems if you cannot make the monthly payment. Pay those first. Then for the remaining bills, divide up your paycheck proportionally and hope your creditors do not complain too much until next month.
Pay Off What You Can
Paying off only what you can also happens in the real world, but is more rare. When using this method, instead of dividing up your paycheck proportionally, you pay off several of the bills in full, leaving others to be completely unpaid until next month. The creditors you do not pay off hate this. You may get angry phone calls or letters, and it could seriously hurt your credit.
If you can borrow some cash, use your credit card, or get a line of credit from your bank, that will be the way to go. If not, you will need to determine which hurts less: dividing your paycheck or paying off what you can. Let’s take a look at how this works.
Step 1: Subtract the Non-Negotiables
The top 3 things on our list are non-negotiable. Any lapse in the bills will cause termination of your service entirely.
Non-Negotiable Bills = Health Insurance + Car Insurance + Cell Phone
= 250 + 30 + 50
We know that no matter what, we need to spend this $330, leaving us with $670 in cash for the remaining bills.
Step 2: Calculate Extra Costs Charged for Unpaid Bills
We want to decide if we are diving our $670 proportionally, or paying off a couple of bills entirely. To see which is best, we first need to know how much extra cost will be applied to the remaining bills if we wait until the next paycheck to make a payment
We want to decide if we are diving our $670 proportionally, or paying off a couple of bills entirely. To see which is best, we first need to know how much extra cost will be applied to the remaining bills if we wait until the next paycheck to make a payment.
|Bill Amount||Late Fee||Late Interest (Monthly)||Bill Plus Late Fee||Interest Charge||Total Due In 30 Days|
$1,300 in bills today will grow to $1,549 next month if unpaid, or $249 more than it would be if we could pay everything today. We can see the biggest hits are coming from rent and credit cards.
We are not getting charged extra for missing payments for the student loan and the car loan, but missing a payment will damage our credit history, and we will accumulate more interest on the principal balance. We will estimate the damage to our credit history being $60 each for the credit card, student loan, and car loan payments.
There is also a chance that our landlord and utility companies will report the missed payments. We will assume there is about 1/6 chance, so we will estimate a “credit damage” amount of $10 for each of those bills.
This means the total damage done by missing every payment this month is $459.
|Late Fee||Interest Charge||Credit Damage||Total Cost|
Step 3: Calculate Cost if Paycheck Is Divided
Next, we want to see what our cost will be if we divide our paycheck proportionally. This means we are not paying any bill in full. We are looking at the proportion each bill represents of the total amount we owe, and dividing our paycheck accordingly. We will still get charged late payments and some interest. However, we will assume that there will be 1/4 the amount of damage to our credit for a partial payment compared to making no payment at all.
|Bill Amount||Percent of Total||Amount We Pay ($670 x the %)||Amount Unpaid||Late Fee||Total Unpaid|
We are paying $150 in late fees alone. Now we factor in the interest charges and damage to our credit that goes with this payment:
|Total Unpaid||Late Interest (Monthly)||Interest Charge||Credit Damage||Total Due Next Month|
To calculate how much this is costing us, we can add together our total late fees, total interest charge, and total damage to our credit:
Total Cost = Late Fees + Interest Charges + Credit Damage
= $150 + $53.57 + $52.50
The total damage is $256.07, which is just $202.93 better than paying nothing at all, but still a big amount.
Step 4: Compare with Paying Off Big Credit Debts First
What if instead of dividing up our paycheck equally, we just pay off what we can afford, and leave the rest? To prioritize, we can take our $670 remaining, go down the list of priorities, and simply pay them off.
|1. Credit card||$80.00||$590.00|
|2. Car loan||$200.00||$390.00|
|3. Student loan||$260.00||$130.00|
|4. Rent||$600.00||Can’t pay – skip|
|6. Internet||$80.00||Can’t pay – skip|
Now we have an unhappy landlord and an unhappy internet service provider, but our other bills are paid. We can now compare this option to how much damage skipping these bills entirely would do:
|Bill Amount||Late Fee||Late Interest (Monthly)||Interest Charge||Credit Damage||Total Damage (Late fee + Interest + Credit damage)|
This gives us a total damage of $149.50, saving over $100 compared to dividing up our paycheck equally. We even still have $50 remaining. Applying the $50 to the internet or rent bill would remove some of the credit damage and the interest charged, saving even more money.
Our calculations show that paying off most bills completely and leaving a few unpaid will be better dollar wise. You will save money on late fees, interest charged, and damage to your credit. However, the reason most people still divide up their paycheck and pay a little to each creditor when faced with a cash shortage is due to the human factor. Every creditor who is not paid will send you emails and make phone calls as soon as your payment is late, demanding payment as soon as possible. So people try to minimize the damage from each creditor instead of focusing on minimizing the damage from every creditor. By keeping the big picture in mind, you will do your spending plan a huge favor!
You can download a spreadsheet showing all of these calculations, and even change the values to match your own bills, by clicking here.