Let’s look at ways to get out of debt without gimmicks or games.
After many years of studying and writing about money, I’ve concluded that debt reduction should be a side effect rather than a goal. Getting rid of debt is a goal, not a habit. And, as we recently discussed, excellent goals are based on actions rather than numbers. If you restructure your life so that you spend less than you make, you will be able to pay off your debt. It is a natural side effect.
Having said that, it seems that many GRS readers are battling to go back to square one. Getting out of debt is their primary objective and obsession. That is okay.
You must earn a profit before you can begin repaying your debts. Unless your income exceeds your expenses, your debt will increase. If you’re still adding debt or can only make minimum payments, you need to find strategies to spend less and earn more until you have a positive “saving rate”. (Both firms and individuals make profits. However, when individuals make a personal profit, we call it “savings”.)
Once you’ve made a personal profit, you may (and should) prioritize debt elimination.
Why Pay off Your Debt
Debt payback can boost your credit score, allowing you to spend less for anything from rent to vehicle insurance to future borrowing needs. Furthermore, debt reduction is one of the most profitable investments.
Investing in the stock market yields an average yearly return of approximately 10%, but this return is not guaranteed. Some years, the market rises 30%, while others it falls 40%. When you pay down a credit card, you get a guaranteed 20% return (or whatever your interest rate is). That’s difficult to beat.
There are also non-financial benefits to paying off debt, including:
- Simplicity. The more debt you have, the more bills you have. It’s easier to manage your money when you have a simple, efficient financial infrastructure. Each time you pay off a debt, you move one step closer to this ideal.
- Cash flow. Whenever you eliminate a debt, the money formerly used for that monthly payment becomes available to pursue other goals – including fun stuff like ski trips and knitting supplies.
- Freedom. When you have monthly payments to meet, you’re chained to your job. You’re unable to take risks. Once your debt is gone, a wider range of options becomes available to you.
- Peace of mind. Best of all, once you’re debt-free, you can sleep easier at night. You’ll put less pressure on yourself, and you’ll have fewer fights about money with your partner.
When I first started to get out of debt, I didn’t have a system. Without a plan, I wired extra money to one credit card after another. As a result, I never seemed to make any progress.
After deciding to take control of my own life, I looked into how to get out of debt. Many literature advocates for a practice known as the “debt snowball”. Even though I was apprehensive, I gave it a try. The method worked. Using it, I was able to pay off my debt and start investing for the future.
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Stop Acquiring New Debt
This may sound obvious, but the reason your debt is out of control is because you keep adding to it. Stop using credit. Do not finance anything. Cut up your credit cards.
That last one can be challenging. Do not make excuses. I do not care if other personal finance websites advise you shouldn’t tear them up. Destroy them. Stop rationalizing your need for them.
- You don’t need credit cards for convenience.
- You don’t need credit cards for cash-back bonuses.
- You don’t need credit cards for a safety net.
Credit cards are not necessary at all. Credit cards can be a trap for those who are in debt. They simply increase your debt. Maybe you can get a credit card later, once your bills are paid off and your finances are in order. (My personal credit card is not with me. I don’t long for one.)
Stop making any further payments after destroying your cards. Cancel your gym membership if you have one. Cancel your World of Warcraft account if it is set to renew automatically. Anything that debits your credit card automatically should be canceled. Give up using credit.
After doing this, give each credit card company a call in turn. With the exception of credit cards with a zero amount, never cancel your credit cards. Ask for a better deal instead. Find a low interest credit offer online and use it as a bargaining wedge. Your bank may not agree to match competing offers, but it probably will. It never hurts to ask.
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Create an Emergency Fund
This seems counter-intuitive to some people. Why pay off debt before setting up money for emergencies? You won’t be able to handle unforeseen costs if you don’t start saving first. Refrain from convincing yourself that you can use a credit card in an emergency. Shred your credit cards and keep emergency cash on hand.
What is the appropriate amount to save? Aim to start with $1,000 in savings. (University students might be able to survive on $500.) Only emergencies should use this money. It’s not meant for beer. It’s not intended for footwear. It’s not intended for a PlayStation 3. It is intended to be utilized in the event of an automobile accident or an arm break during a touch football match.
Maintain this cash on hand, but keep it out of reach. Keep your emergency fund separate from your debit card. Don’t undermine your efforts by making it simple to squander the cash on unnecessary items. Think about creating a savings account online. You can quickly move the funds to your regular checking account in case of an emergency. You won’t be able to spend it on the spur of the moment, but it will be there when you need it.
The Debt Snowball
When using the debt snowball method, you allocate a certain sum of money each month to pay off your debt. First things move slowly. But eventually, you start moving quickly forward and gaining momentum much like a snowball going downhill.
Step one
List all of your debts as a first step. Include the amount you owe, the interest rate, and the minimum payment for each commitment. Put the debt with the greatest interest rate at the top of the list. The loan with the second-highest interest rate is listed next, and so on, until you get to the debt at the bottom of the list, which has the lowest interest rate.
Step Two
After you’ve made a list of your debts, determine the total monthly payment amount you can afford to make. This ought to be greater than your minimum payments—$508 in the case above—but at least that amount. In my situation, I began by setting aside $700 per month to pay off debt.
Step Three
Make the minimum payments due each month on all of your debts, with the exception of the one that has the highest interest rate. Pay down the debt with the highest interest rate using the remaining funds you have set aside for debt reduction.
With a fifteen percent interest rate, the computer loan was the largest debt I had. The total monthly minimum payment for all other debts was $460. In accordance with this strategy, I would subsequently apply the remaining $700 that I had set aside each month for debt reduction to the computer loan. I would pay $240 as opposed to the required minimum payment of $48.
Step Four
Repeat this process every month until the debt at the top of the list has been eliminated.
Step Five
This is where the power of this strategy lies. Once your initial loan is paid off, you don’t spend your extra cash flow on new purchases. Rather, you take the additional money and use it to pay down the next bill on your list.
For example, if I start off putting $700 toward debt each month, I keep putting $700 toward debt each month until it’s all paid off. I retire the computer debt first, then turn my attention to the business loan. I could set aside $270 per month to pay off the business debt because the minimum payment on my other bills would be $430.
I would then pay $370 a month toward the home equity loan and so on after the business debt is paid off.
Ultimately, I’d be left with a single loan: the $6430 personal loan at 0% interest. Every month, I’d apply all $700 to get rid of this debt.
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Pros and Cons
The debt snowball is a potent and successful tool. It makes the most sense financially to pay off your debt. There is only one issue.
You will ultimately pay less money if you pay off your loans in order of highest interest rate to lowest interest rate. Sadly, a lot of people—including myself—find life challenging. When I got to my home equity loan, the third debt on the list, I encountered a brick block. Repaying that $21,000 amount would take years. That was not my level of patience.
Thankfully, I discovered there were additional methods for sorting your obligations. It’s not necessary to deal with the high interest rates initially.
Building a Better Snowball
People are intricate, psychological beings. No further machines are being added. Even while many of us know what is right, it can be challenging to really make the greatest decisions. (We wouldn’t have accumulated consumer debt in the first place if we were installing machines!) Telling someone who is deeply in debt that they have to stick to a repayment schedule that minimizes interest payments is a bad idea. Putting in place a system of positive reinforcement is crucial.
This is why a lot of individuals favor very little modifications to the debt snowball strategy. These approaches prioritize psychology over arithmetic.
Dave Ramsey’s Debt Snowball
One version of the debt snowball has gained popularity thanks to financial guru Dave Ramsey. He advises targeting the loans with the lowest balances first, rather than arranging them according to interest rate.
Here’s an example that would be arranged using Ramsey’s method:
- Computer Loan: $1116 @ 15% ($48 min)
- Personal Loan $1600 @ 3% ($100 min)
- Car Loan $2250 @ 5% ($170 min)
- Business Loan $2800 @ 11% ($30 min)
- Personal Loan $6430 @ 0% ($60 min)
- Home Equity Loan $21000 @ 6% ($100 min)
I would make minimum payments on all of the debts except the highest-ranked obligation, just like with the traditional debt snowball strategy. I would throw whatever else I’ve set aside each month to pay off debt at it. I would proceed to the debt with the next lowest balance once the highest obligation was paid off.
Ramsey’s approach takes longer than paying off high-interest debt initially, and you will ultimately lose a little bit more due to interest payments. (For me, the estimates indicated that it would take an additional month to pay off my loan and that I would have to pay $841.15 in interest.) But there’s a psychological benefit to approaching things in this manner.
You obtain some early wins and a mental lift by starting with your smaller debts. This psychological boost gives you even more incentive to continue tackling that debt. You enjoy the satisfaction of paying off a loan every few months! As Ramsey puts it, “behavior modification over math,” and he is not incorrect. In reality, I paid off my personal $35,000 in debt in 39 months by using this version of the debt snowball strategy.
Adam Baker’s Debt Tsunami
There’s a third option that some experts, like Adam Baker from Man vs. Debt, advocate, which they refer to as the debt tsunami. They contend that it’s advisable to settle your obligations in order of emotional impact. As they say, tackle your debts in order of lowest balance to highest, but for an extra psychological boost, give priority to any bill that really bothers you.
Baker admits, “I used to be addicted to gambling and I had debt that was specifically related to gambling.” Paying that off first altered who I am as a person. While it was fantastic to pay off the $600 balance on my credit card, it didn’t change who I was. It did not imply that I would live in a different existence or that my life would be different.”
However, clearing his debt from gaming held significance for him, so Baker tackled that initially.
Here’s a more illustration: A lot of people take out loans from their parents. Even while these loans could have interest rates as low as two or three percent—or perhaps none at all—they come with a lot of psychological baggage. Here is another situation where paying off low-interest debt first might make sense due to the substantial non-financial benefits.
It doesn’t really matter what sequence you pay off your bills in; the most essential thing is to pay them off. Discover a system that suits you, then cultivate the self-control to follow it through.
Note: Repaying low-interest debt is not as important. Businesses employ “leverage” to obtain low-cost loans, enabling them to generate bigger profits in other areas. You do the same thing whether you take out a low-rate mortgage (say, three percent) or use student loans to fund further study (which should yield large profits down the road). Naturally, paying off all of your debt is a wonderful idea, but paying off your mortgage should be a long-term objective rather than being thrown into the debt snowball.
Supplementary Solutions
As you work on these three phases, you can take other actions to help your financial condition.
First, remember the basic formula for personal finance: you need to spend less than you earn in order to save money, pay off debt, or build wealth.
Reduce the amount you spend. Regain your thrifty habits. (The majority of college students are all too familiar with being frugal.) There are some fantastic ideas in this site’s archives. Check Frugal for Life as well.
As you strive to reduce your expenses, take steps to boost your earnings. Sell some of the items you purchased when you were in debt, if at all possible. Take on another job. (However, don’t sacrifice your education in order to increase your income. Your studies are most important.)
Lastly, check out Dave Ramsey’s The Total Money Makeover at your neighborhood public library. This is a great book for paying off debt and creating sound financial habits, so don’t be put off by the title. I gush about it a lot, but that’s only because it has greatly improved my personal financial situation. Return it after you’re done and take out another money-related book.
Simple, Not Easy
People are complicated animals. Not all of us are really logical. There are those of us who are sensitive. Most people fall somewhere around the middle. We rarely follow the best course when making decisions; instead, we typically go with what would make us pleased in the moment. It’s just what occurs; I’m not arguing that this is the proper course of action. It can be challenging to change financial behavior for people who frequently make emotional decisions.
It’s like stating that running a marathon is easy, so why can’t everyone run one? To complain that personal finance is simple and “why doesn’t everyone do what they ought” is equivalent. Though few of us have the commitment and mental toughness to finish one, the majority of us know how to train for one: eat well and run a ton. However, most people can finish a 10k run with a little perseverance and discipline.
The same holds true for personal budgeting. Saying something like “You must spend less than you earn to build wealth” is simple, but putting it into practice is harder, especially in the long run. Developing money is harder than training for a marathon, in certain aspects. Training for and completing a marathon takes months. Dedicating yourself to a sensible financial plan is a lifetime process.
We would all be wealthy if knowing personal finance was really that easy. However, it’s not. Furthermore, we’re not. For this reason, I believe that every little financial success matters. I maintain this website and offer any advice I can discover because of this.
Doing what works for you is what I always advise. In order to succeed, some people must pay off high-interest debt first. However, for other people, including myself, the only way they have succeeded is by attempting a different strategy. From a mathematical perspective, the strategy might not be the greatest, but in my opinion, any strategy that genuinely aids in achieving objectives is preferable than one that does not. Personal finance concepts might be simple, but that doesn’t mean they’re easy. I don’t mean to imply that they are. It took a lot of hard work (and a little luck) for me to get out of debt. It didn’t happen quickly, and it wasn’t easy.
The Bottom Line
As I stated at the beginning, I now think that paying off debt is a consequence rather than an objective. That should not be your main focus.
You’ll pay off debt organically if you take the other steps I suggest, which include developing a personal mission statement and increasing your profit margin. But after your debts are paid off, you’ll have access to a benefit that many others do not.
As you can see, after they have paid off their debt, many people feel disoriented. There are a ton of discussions and queries regarding what to do next when you search online. Their aim was to repay their debts, but that reason has now vanished. They consequently lose their financial course. Sadly, some of the recently debt-free find themselves reverting to their old behaviors, much like a dieter who had set their sights on weight loss rather than a lifestyle adjustment.
You will become debt-free if you are actively establishing positive habits and working toward other objectives. And the good times will last after you pay off your debt: The snowball of debt you have been accumulating will turn into a snowball of money.
Best wishes! You’re heading toward financial independence!
