By John R. Berry
Debt can be a huge mental burden and barrier to achieving your goals in life. Folks struggle with car payments, credit cards, mortgages, and payday loans.
While individuals have varying levels of comfort with debt, feeling buried in seemingly never-ending payments can affect your home and work life, disrupting relationships that are valuable in supporting your debt reduction journey.
Below, I work through six steps to help guide you on your path out of debt.
Step 1. Admit the problem. You are still reading, so in all likelihood you know your debts are a problem. Regardless of the type of debt you have or how much you owe, you believe that it is important to get rid of it.
Maybe it’s keeping you up at night, or forcing you to scrimp at the end of each pay period. Having too much debt can be incredibly stressful.
Step 2. Assess the situation. How much do you owe and to whom do you owe it? Make a list! It may be painful to write a list of your debts that run into the tens or even hundreds of thousands of dollars. The more you dread this step, though, the more important it is for you to complete it.
Here’s an example:
Debts owed:
Car Loan 1: $10,000
Car Loan 2: $23,000
Credit Card 1: $5,000
Credit Card 2: $3,000
Other Loan: $20,000
Total Debt: $61,000
Laying it out like this may help you stop thinking about your debt as a series of monthly bills. If you pay your water bill monthly, you’re caught up. This is not the case for debts like credit card payments! Putting only the minimum toward your credit card bills each month is taking the long, expensive way to paying off your debt.
Step 3. Make a budget. While budgeting is an entire book on its own, I’ll give a brief overview. Know what you make and what you spend. Spending more than you make can be disastrous for your finances, and it’s a reason a lot of people rely on credit cards and even payday loans to “make it.”
Make a list of all your bills and expenses using your last 3 months of bank statements. The averages for those months would be a good place to start to develop a “spending plan.” Then track your spending to make sure you stay within your plan. Add a line for “extra debt payment.” If you find you are spending more than you make and can’t make extra debt payments or even the minimums, cut back immediately on leakage areas. Common problems are eating out too much and indulging in retail therapy, often with credit cards. Also watch for cash withdrawals where you cannot track what happened with the funds. Every penny counts!
Step 4. Establish an emergency fund if you do not already have one. Many people fall deeper into debt because they do not plan for emergencies adequately. You don’t know how an emergency will strike, but rest assured that one will probably come. It’s important to have access to cash in a savings or money market account in case your hot water heater breaks or you have a car accident. People who don’t have cash on hand are tempted to whip out the plastic.
How much do you need in an emergency fund? $1,000 is commonly stated as a starter goal. If that sounds too big, start with $600—that’s $50 per month for a year. Especially if you have a family or a fragile income, it’s ideal to have several months of living expenses saved up in case of long-term inability to work or other emergency.
Step 5: Now that you have your budget and emergency fund set up, it’s time to tackle your debt. Beating debt requires a plan. I am going to focus on three ways to accelerate your journey to debt freedom.
The first way is relevant to the other two strategies I’ll discuss, and it works really well if you have just one debt. That’s to pay more than the minimum.
For example, if you have just that $5,000 credit card balance referenced above costing 13% interest, it will hang around for four and a half years if you pay $150 per month, but if you pay $350 monthly the debt will be erased in about 16 months.
If you have more than one debt, you have choices. Sometimes people freeze at this point because they don’t know where to go from here, but the underlying principle is the same: pay more than the minimum on something.
Let’s talk about the avalanche method. The avalanche method is where you list your debts by interest rate highest to lowest, and then tackle them top to bottom.
Our list above would look like this:
Credit Card 2 $3,000 17% (pay off first)
Credit Card 1 $5,000 13%
Other Loan $20,000 8%
Car Loan 1 $10,000 4%
Car Loan 2 $23,000 3%
To avalanche, pay all the minimums but dedicate extra payments to the debt with the highest interest rate. When you have paid that off, add what you were paying toward the first debt to the debt with the second highest interest rate and so on until you have paid off your debts. This is the fastest way to pay off your debt, but you won’t necessarily pay off individual debts sooner.
The second method often used to aggressively pay off debt is the snowball, used by many debt counselors. This involves paying off small balances first and then allocating those funds to the other debts.
So our debt list would look like this, in order of payoff priority:
Credit Card 2 $3,000 17%
Credit Card 1 $5,000 13%
Car Loan 1 $10,000 4%
Other Loan $20,000 8%
Car Loan 2 $23,000 3%
People who use this method enjoy seeing those smaller debts disappear quickly. It can give you motivation to keep going, as well as some psychological victories that are quite important in your quest to eliminate debt.
Paying off debt can be as much a mind game as a financial challenge, so you want to consider your specific situation, your level of motivation, and your personality when embarking on a debt paydown strategy. Regardless of the method you choose, always pay more than the minimum on something and don’t stymie your plan by adding to your balances.
Before I wrap up, I’ll mention a few possible exceptions to consider when deciding which balances to pay off first. First, are payday loans. They are usually borrowed at small amounts with very high interest rates, so they’d probably fall at the top of your list whether you decided to do an avalanche or a snowball payoff. You should consider paying these off as soon as possible due to how high the interest is and how quickly a small loan can turn into a huge obligation.
Also, if you have student loans or mortgages, talk to a financial professional such as a CPA about where to include them in your debt payoff plan. In many instances the interest on this type of debt is tax deductible.
Step 6. Lastly, make sure that you don’t fall into unwanted debt again. You can help yourself here by bolstering your emergency fund.
You also need to take ownership of your finances, part of which involves keeping in check the behaviors that create overspending. Some people try to keep up with the Joneses, while sometimes honest-to-goodness emergencies happen, requiring that we take on debt. But most of the time assuming fresh debt can be avoided by careful planning and having adequate resources to cover the things that life throws your way.
CERTIFIED FINANCIAL PLANNERTM professional John R. Berry is owner of Corner Post Financial Planning in Mineral Wells, Texas. Contact him at (940) 325-9800.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.