Perhaps it was the recent recession. Or it could have been a promotion or a new, higher paying job. It might even have been the realization that unless something changed, you would be paying off debt until sometime after you turned 92 as long as you kept your job. No matter what it was, you’ve decided that being debt free is the new path for you.
Good job! Making the decision is the first step and in many ways the hardest. This is not to say that the other steps to becoming debt free are easy but it is something that can be done and depending on your starting point, can be accomplished in a relatively short period of time or it could take years and years. Don’t get discouraged, even if it does take several years you will be better for it much sooner than you think.
Before going into the detailed steps of getting out of debt, it is best if we classify the three types of debt because different types of debt require different types of actions because of how the debt works. The three types of debt are revolving debt, installment debt and mortgage debt.
Mortgage debt is the debt you have because of where you live. The good thing about this type of debt is that you can reduce your taxable income by the interest you pay on the loan and generally, unless you were forced into an upside down position (you more than the property is worth) you can sell the property and eliminate your debt. You will still need a place to live so the expense doesn’t go away. This isn’t to say that you should sell your home! Look at your situation and it may make sense or it may not.
Installment debt is a debt that will be paid off in a set number of payments. Examples are things like cars, bank loans and things that have a set term besides your house.
Revolving debt is something that you pay every month and the unpaid balance earns interest for the company which is added on to your balance. The net effect is that in some cases, making the minimum payment every month will never pay off the card or will take anywhere from 8 to 12 years if not longer. Most revolving debt has the highest interest rate and is generally seen in credit cards and store credit cards. This is the worst kind of debt for most people as they rarely are fully aware of how much they owe when they whip out the plastic to pay for something. This is also the type debt reduction we will address first.
The Steps To Becoming Debt Free
Step 1. Make the decision to be debt free! Hopefully you have already made this decision and you are ready for the necessary changes you will need to make to complete your journey. The freedom you will achieve with being debt free will make the effort worth it!
Step 2. Assessment. Before you can get somewhere, you need to know where you are at! At this point we record all debt, the minimum payment and the payment necessary to actually reduce the principle, the interest rate and the balance owed. Do this on paper or on an Excel type worksheet and have separate pages for each type of debt, revolving, installment and mortgage, Now, arrange them in order of amount owed from lowest to highest owed. Determine how much money you owe each month based on your required payments.
Step 3. Make a budget. Here you will need to include everything that you own and are obligated to pay on a monthly basis. This also includes a food budget, clothes, necessary services, utilities, insurance and vices such as drinking, smoking and coffee. (OK, coffee is required in my world, but premium coffee prices are not.)
Step 4. Armed with your new budget, follow it for three months and as you discover what works and doesn’t work, refine it so that after three months you have a workable and working budget. At this point you may have noticed that we haven’t addressed paying off any debt yet. This is true! If you don’t have a working budget it just doesn’t work unless you have so much extra cash that paying off debt is just another minor chore and if you are like most people, this isn’t the case. A key point in this phase is that you must stop increasing your debt and this means to stop using your credit cards, taking out any loans or using that home equity line of credit.
Step 5. Pay off some debt! At last, we can finally pay down some debt. Actually, depending on how good you were with your budget process, you might not have needed three months and if that is the case for you, great! Hopefully your budget allowed for some small surplus at the end of each month. With this small surplus, put it toward the smallest debt which will likely be revolving (credit card) debt or installment debt. If it is revolving debt, after a few months this may actually reduce the minimum required payment as some companies will reduce your payment by the amount you are ahead. Don’t be fooled by this! Stay on budget and keep paying your scheduled amount plus your surplus.
Step 6. Celebrate! After you pay off that first debt and see a larger surplus in your budget, take the time to celebrate your success. Have a special dinner with close friends of family members. The key part here is that you must not celebrate using a credit card! Make this a “cash only” event!
Step 7. Repeat Step 5 and keep going through this cycle until all your debts are paid off. With each paid off debt you should have a little more surplus in your budget and before long your debt reduction rate will be very impressive and you will be on your way to being debt free.
No discussion of becoming debt free would be complete if we didn’t discuss a few other things.
What if your required payments for debt and living expenses are more than your income?
This looks like it will take forever, how can I make this work faster?
Some possible solutions include:
Change your tax withholding to an amount that will give you a refund of only about $100-200 dollars. There is no need to give the IRS a free loan of your money. You need that money now so you can pay off your debt and live!
Take a part time job if at all possible. Anything at all as long as it gets you into positive territory on your budget.
Look for things you own that you can sell on e-bay or Craig’s list.
Reevaluate your budget for things like food and clothing. It is OK to eat chicken instead of beef and unless you are a runway model you don’t need the latest fashions right when they come out, use the sale racks and buy timeless pieces of clothing instead of the current “hot” thing.
Reevaluate your vices. Try cutting back on smoking to half what you do now or better yet quit as you will save money on the vice, health care, dental work and cleaning.
Reevaluate your entertainment expenses. Catching two movies a week, the theater or a pro ball game every week may be excessive if you have to live on credit in order to do that.
Reevaluate your hobbies! Can this be a money maker? Is it something that you should scale back on until you have a better cash flow situation? You make the call!
Look at the possibility of a consolidation loan or a home equity loan that can lower your interest rate and reduce your payments. It does no good to do this if the payments are higher and put you into negative budget territory. This is one of those things that need to be evaluated on a case by case basis. The key point here is that unless you change your habits and way of life, you will soon find yourself in even worse shape because you will have a bigger loan and the newly maxed out credit cards.
Another thing that has to be evaluated on a case by case basis is the credit card offer that promises low rates for a year on balance transfers and then goes up to their standard rate. Read the offer carefully because this may actually be a good deal depending on your other cards’ interest rates but be very careful and ether cut up or burn the old card (or at least lock it up!) so that you don’t charge it up again.
The great thing about these “extra” solutions is that they will work for you even if you are in great shape on your budget or just want to reduce debt because of the uncertainty of the economy.
So what about that house mortgage? Once your other debts are gone you can apply the same system to your mortgage. Keep in mind that if you have a standard 30 year mortgage and you are able to pay one extra payment a year, even if you split it up over 12 months, then you will turn your 30 year mortgage into a 23 year mortgage and save yourself 7 years worth of house payments!
So, there you have it, and while it may sound easy, it can be difficult and it does require discipline. But the rewards are well worth it, because if you can get there, the next economic crises will not be a crisis for you and your family. You will be financially secure, and won’t have to worry about your credit being destroyed or of losing your house. And that is a very comforting thought!