Competitor: This article comes from Megan at TheFinanceGeek.com.
Entry Category: Strategies for Getting out of Debt
My sister called me the other day, completely stressed out. In her words:
“[My inlaws are in town and they] keep taking us places and it costs money and we don’t have any. And so we have to keep making credit purchases.”
Her level of stress was understandable considering she already had a not-inconsiderable balance on her credit cards.
This is not to say that my sister dislikes her in-laws. On the contrary, they’re wonderful people. But my sister is a stay-at-home mom, and while she and her husband do well enough on their single income, they’re still in that “just starting out” phase of life/marriage. There’s not a lot of room for luxuries in thier fledgling budget and they don’t have much in the way of savings. (Hence the existing credit card debt.)
So, now she has a little over $6,000 in credit card debt, with the likelihood of adding a few hundred more before her in-laws head home. Like I said, stress (and a little panic) was a totally understandable reaction.
But people have paid off a lot more than $6,000 in (credit card) debt, so I told my sister not to panic, and laid out a plan.
Digging Up: Where to Begin
Debates have raged in the Personal Finance Blogosphere (and elsewhere) about the best way to pay down your debt. Some say that paying off the smallest balance first is better because of the psychological boost. Others say that it only makes sense to pay off the highest interest balance first, because it saves more money in the long-run.
Here’s what I say (going along with the “digging” metaphor): Just pick any shovel and use it.
It doesn’t really matter which one, as long as it works for you. And, if you have trouble with it, for whatever reason, take a step back and re-evaluate, and maybe pick up a different shovel.
Others have said it before, but it bears repeating, Personal finance is just that, personal. It doesn’t matter how you go about digging yourself out of debt, as long as you start.
That being said, what I told my sister was more specific than “just do something.”
A Step-By-Step Plan
Step 0: Know how much money you have coming in and going out each month
This is an important pre-step, because before you can start paying down your debt, you have to be living below your means (spending less than you’re bringing in). I could write an entire blog post about just this (and I have), so let me just say here that until you have solid information on how much extra you can spare each month for saving or paying down debt, you won’t be able to make any real progress.
Step 1: Make sure you and your partner are both on board with the “get out of debt” plan
If your partner doesn’t agree that it’s a good idea, you’ll have a much harder time sticking to your budget, putting any extra toward your debt, or following any of the other steps to come. There is nothing harder than trying to make progress on a financial goal when your partner is ambivalent, or worse, actively against it.
Once you’ve got a plan for digging your way out, sit down and share it with your partner and make sure they’re on board.
Step 2: Stop spending on your credit cards
The fastest way to backslide when you’re digging your way out of debt is to keep using the cards you’re trying to pay off.
You don’t have to close the accounts (in fact, for the sake of your credit score, please don’t), but take them out of your wallet and put them someplace safe. “Out of sight, out of mind” works pretty well, but if you’re having trouble with that, Google “how to stop using credit cards” or some variation thereon. There are lots of methods, including freezing your cards in a block of ice.
Step 3: Save $1,000 for a Beginner Emergency Fund
When I first got interested in figuring out how money works and what to do with the (student loan) debt I’d accumulated, one of the first books I read was by Dave Ramsey. Now, I don’t subscribe whole-heartedly to his approach to paying down debt, but I do think he’s on to something with his “Beginner Emergency Fund” idea.
It may seem counter-intuitive to save instead of immediately jumping in and paying off your debt. I mean, while you’re saving that $1,000, interest is accumulating, right?
But here’s the thing: that $1,000 beginner emergency fund is your safety net. Without it, should something go wrong (like your AC dying in the middle of a 100+ degree heatwave), you’d have to rely on your credit cards to get you out of the mess, which puts you right back where you started, if not even further in the hole.
Plus, having even a small amount of money saved up “in case of emergency” can be a great psychological boost, relieving stress you may not even know you were carrying.
Important: If you spend money out of your emergency fund, replace it before you go back to paying off your debt. That way it’s there for you if you need it again.
Step 4: Organize your debts in the order you’d like to pay them off
As I mentioned above, you could spend hours (days) online getting all sorts of advice on the best way to organize this list, but the key thing is to pick a way and stick with it.
The method that worked for me, and what I suggested to my sister, was to group the debts by type (credit card, car loan, student loan, etc.), and then organize them by balance.
For my sister, who has three kinds of debt at the moment, I suggested the following order:
Credit Cards (highest interest rates over all)
Car Loan (smaller balance than the mortgage)
Mortgage (best interest rate of the lot, despite larger balance)
Step 4(b): Consolidate if that will help you
Balance-transfer credit card
One of the things my sister asked me was if putting all of her credit cards on a 0% APR balance transfer card was a good idea.
My response? It’s not not a good idea. I mean, as long as you have a solid plan for paying off the amount you’re putting on the balance transfer card before the initial offer expires, it can be a great idea.
But there’s a catch. Often, if you haven’t paid off that original balance transfer by the time the offer expires, you have to pay interest on the full amount of the transfer, which can be a pretty significant slide in the wrong direction.
Along similar lines, if you’re starting with non-credit card debt, a consolidation loan can be worth looking into. But, be aware, there may be fees and other costs or catches associated with loans of this type that make them less of a good deal. Just make sure you thoroughly research and know what you’re getting yourself into.
Step 5: Pay down the first debt on your list
Remember back in Step 3 when I told you to use any extra money in your budget to start saving for your emergency fund? Once your emergency fund is funded, that same amount of extra money is going to go toward the first debt on your list. You should keep paying the minimum amount required, plus the extra money.
Side note: while you’re working on paying down your first debt, make sure you keep making the minimum payments on your other debts. Those other minimum payments should already be factored into your budget, but it bears mentioning. Defaulting on your loans is bad.
Step 6: Throw whatever extra at it that you can
If, throughout the course of a month you get a windfall (you find $20 in a winter coat; you make a little money babysitting your neighbor’s kids; your mom sends you $100 for your birthday), put it toward your debt.
If you thought you were going to spend $350 at the grocery store and you only spent $300, put that extra $50 toward your debt.
If you thought your electric bill for June was going to be $150 or more because of the crazy heatwave, but it was only $90, put that extra toward your debt.
You get the idea.
Step 7: Rinse and Repeat
When you’ve paid off the first debt on your list, you have a fun choice to make: Do you take the money you were putting toward that first debt (the minimum payment plus the extra) and put it toward the next debt? Or do you do something else with it?
By “something else” I don’t mean blow it on some frivolous purchase. To give you a personal example, when we paid off our first credit card, the money that we were spending on that debt went straight toward our next credit card. However, when we paid off our first car loan, we took half the money we had been paying toward the car and started putting it in savings (for car repairs, the next car, etc.). The rest of the monthly payment and the extra we’d been putting toward our debt the whole time got rolled into our next debt pay-off goal.
That’s all there is to it! Simple but not always easy.
Getting out of debt isn’t complicated. It’s time consuming, sure, and it takes willpower, patience, and diligence to stick to your plan. In the end, though, it’s pretty straightforward: stop spending on credit, spend less than you earn, use the extra to pay down your first balance, move on to the next debt.
The last piece of advice I would give is to give yourself a way to easily track your progress. As an example, I know someone who made a paper ring chain that represented her debt. Every ring was $100 and she used a different color for each card or loan. For every $100 she paid, she removed a ring.
My method is a spreadsheet with a different tab for each debt. As soon as I pay off a debt, I delete that tab. We started with 13 tabs. We now have 7. It’s not a method that would work for everyone, but it works for me. Giving yourself a tracking system will help you stay on track and motivated toward your goal.
To my sister, and anyone else out there who’s trying to dig their way out of a debt hole (no matter how deep), good luck. I know you can do it.