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When you're in debt you start to notice all the late night get-rich-quick infomercials with increasing frequency. Spare yourself the time-suck and impact to your sleeping habits with this excerpt on the basics of debt reduction from J.D. Roth's Your Money: The Missing Manual.
Many people look for magic bullets to get them out of debt: They play the lottery hoping for a big payout, or they listen to the snake-oil salesmen on TV who promise instant solutions. The truth is, there aren't any instant solutions. There are, however, some time-tested, proven techniques.
Real debt elimination involves three main steps: Stop accumulating new debt, establish an emergency fund, and destroy existing debt. In the next three sections, you'll learn about each step in turn.
Tip
Being in debt because of student loans or a medical emergency is different from being in debt because you spend too much. If spending isn't your problem, you can skip to the section on establishing an emergency fund (the section called “Establish an Emergency Fund”). For advice on paying off student loans, check out http://tinyurl.com/st-loans; and you can find an article about medical debt from Smart Money at http://tinyurl.com/doc-debt.
If your debt is out of control, it's because you have a negative cash flow—you're spending more than you earn. The first step on the path to debt-free living is to reverse this cash flow. For most people, that means it's time to stop using credit; credit makes it way too easy to spend more than you have.
Nobody needs credit cards. Don't try to make excuses for why you have to keep them: You don't need them as a safety net, for convenience, or for cash-back bonuses—you can get by without them. (Turn to the section called “Your Credit Report” to read about someone who lives without credit cards.) If you've had problems with credit cards, the worst thing you can do is hold on to them. It's like an alcoholic keeping a couple beers in the fridge in case he gets thirsty. When your debts are gone and your finances are under control, then you can get a credit card; in the meantime, make do with a debit card.
It can be tough to quit credit cold turkey; I know from first-hand experience that it's easy to find reasons to whip out the plastic. If you're really struggling with credit-card debt, your best move is to remove the temptation completely: Destroy your credit cards. Don't put them in a desk drawer, and don't freeze them in a block of ice; you're better off shredding them, burning them, or cutting them into tiny pieces with scissors.
After you destroy your cards, halt any recurring charges. If you have a gym membership, cancel it. If you automatically renew your World of Warcraft account every month, cancel it. Cancel anything that automatically charges your credit card. The point is to completely stop using credit.
Once you've done this, you'll need to decide whether you're going to close your credit card accounts or leave them open. If you try to cancel a card that has a balance on it, the issuer may want to jack up your rates or do other evil things. Plus, it'll ding your credit score (see the section called “How and When to Cancel a Card”). But so what? If you have trouble with credit card debt, you've got to remove the temptation; if you don't close your account, you can still use it to shop online even if you've destroyed the card. Besides, when you call to close your account, some card issuers will let you lock in a lower rate by putting you on a payment plan.
If you simply have to leave your account open, then ask for a better deal. Find an offer online to use as a bargaining chip. When you call, say something like this:
"Hi. I was just browsing online at CardRatings.com and I see they have a card from [Other Bank] that has an APR of just 10%. I'm paying 18% APR on the card I have with you. I'd rather not switch, but 8% is a lot. Is there anything you can do to help me out?"
Your bank may not agree to match the terms, but then again it might. You'll have better luck if you've been a long-time customer, paid on time, and used the card regularly. Be friendly but insistent, and don't make any threats you're not prepared to follow through on.
The next step is to sock away some savings. Use that positive cash flow you're building to set aside a little self insurance, money you keep on hand in case of emergencies. This helps you cut costs because it's cheaper than paying an insurance company to handle unexpected catastrophes. (See the section called “General Insurance Tips” for more about self insurance.)
It may seem counter-intuitive to try to save up a little bit of money while you're still in debt, but if you don't save before you begin paying down debt, you'll struggle to cope with unexpected expenses.
Tip
Whatever you do, don't use a credit card to pay for emergencies; a credit card is not an emergency fund. Instead, destroy your credit cards and save for emergencies.
How much should you save? Ideally, $1,000 is a good amount to start with. (If your expenses are low, you might be able to get by with $500.) Keep this money liquid, but not immediately accessible. In other words, make it easy to get to—but not too easy. Don't keep your emergency fund in your main checking account, for example; consider opening a separate account at a new bank. (Chapter 7, Banking for Fun and Profit has tons of info about bank accounts.)
Don't tie your emergency fund to a debit card; that just makes it easier to sabotage your efforts by using the debit card to pay for non-essentials. This money is for emergencies only, not for beer, clothes, or a new iPhone. It's for when your furnace croaks or you break your arm or you lose your job.
A good option is to open a high-interest savings account at an online bank like ING Direct or HSBC Direct. (For a list of online banks, check out http://tinyurl.com/savingACT or flip to the section called “Online banks”.) That way, when an emergency arises, you can transfer the money to your regular checking account. It'll be there when you need it, but you won't be tempted to spend it rashly.
After you've stopped using credit and created an emergency fund, then go after your existing debt. Attack it with vigor—throw whatever you can at it. The best way to do this is to use a technique called the debt snowball, which lets you build and maintain debt-destroying momentum. Here's the basic method:
Make a list of your debts in the order you want to destroy them. (You'll learn a couple of good ways to prioritize debts in a moment.)
Set aside a certain amount of money to pay toward debts each month ($500, say).
Make the minimum payment on all debts except the first one on your list.
Throw every other penny at the first debt on the list.
But here's the key to making the debt snowball work: After you've destroyed your first debt, you'll find you've freed up a bit of cash; because one of your debts is gone, you have one less monthly payment. You could take this money and use it for something else, but you're going to do something smarter: keep paying the same total amount—$500, in our example—toward debt every month.
Clear as mud? Let's look at a couple of examples that prioritize debt reduction in different ways.
Conventional wisdom says that you should pay off debt from the highest interest rate to the lowest interest rate. Let's say our friend Joe Spendsalot (the section called “Cash Flow Basics”) is dating a woman named Karen Kashout. Karen is a typical twenty-something who wakes one morning to realize that she's in debt, and she decides to do something about it. She's burdened with the following liabilities:
$20,000 student loan at 5% interest
$8,000 credit card balance at 12%
$2,000 computer loan at 10%
$3,000 car loan at 4%
Technically, the quickest way for Karen to conquer her debt is to pay off the balances with the higher interest rates first, so she'd tackle them in this order:
$8,000 credit card balance at 12%
$2,000 computer loan at 10%
$20,000 college loan at 5%
$3,000 car loan at 4%
Using the debt snowball method described above, Karen would pay the minimums on the bottom three debts and throw all the money she could at her credit card balance. Once she destroys that debt, she'd pay the minimums on the bottom two debts and throw all of her money at the computer loan, and so on.
Mathematically, the high-interest payoff plan does indeed make the most sense. That's because paying interest works against you in the same way that earning interest works for you (see the section called “The Power of Compounding”), so paying off your highest interest debt first is technically the best use of your money—if you follow this plan, you'll pay less in the long run. But this plan works only if you have the discipline to stick to it, and even if you know it's the right thing to do, that's no guarantee it'll work for you.
I struggled with debt for a decade (see the box on the section called “The Basics of Debt Reduction”). I made several attempts to pay off my debt using this highest-to-lowest interest method, and each time I failed. My highest interest rate debt was also my debt with the highest balance, so I felt like I was paying and paying but the balance never dropped. I'd get discouraged and give up on ever paying off my debt.
That's not to say you shouldn't try this method: If it works for you, use it! But if you struggle, consider the next method, which is the one that helped me succeed.
Tip
It might help you to have a visual representation of your debt-paying progress. Try this: Take a piece of graph paper and block off squares to represent your debt. (You might use one square for every $100, say.) When you make a payment, mark off a square—and give yourself a pat on the back. (If you're a geek, build yourself an Excel spreadsheet that does something similar.) These little progress reports are cheesy, but they can keep you on track.
If you've tried following the highest-interest-rate-first advice and still struggle with debt, there's another way. In his book, The Total Money Makeover, Dave Ramsey advocates an approach to the debt snowball that tackles accounts with low balances first. (Ramsey didn't invent this method, but he's popularized it over the past decade.)
With this version of the debt snowball, you ignore interest rates when determining the order in which you'll pay off your debts. All you look at is how much you owe, organizing the debts from smallest balance to largest balance.
Our friend Karen Kashout, for example, would arrange her debts like this:
$2,000 computer loan at 10%
$3,000 car loan at 4%
$8,000 credit card balance at 12%
$20,000 college loan at 5%
After she lists her debts from smallest to largest, she'd make the minimum payment on all of them except the smallest: the computer loan. She'd throw every dollar she can at the computer loan until it's gone, and then move on to her next smallest debt, the car loan.
This method may not be as quick as paying your high-interest debt first, but it provides tremendous psychological reinforcement. You get some quick wins—checking creditors off your list—that encourage you to keep at it. Dave Ramsey calls this "behavior modification over math," and he's right: The most important thing when paying off your debts is to, well, pay off your debts; the order in which you do so is irrelevant.
Critics of this approach argue that the math doesn't make sense, and they're right: If you use this method, you will pay more interest than if you had the discipline to pay off your debts based on interest rate. But humans are complex psychological creatures, not adding machines. We usually know what we ought to do, but that doesn't mean we always do it. If we were adding machines and always made the best choices, we wouldn't get into debt in the first place!
You can use the debt snowball to get out of debt in other ways. For instance, you might decide to first target the debts that give you the biggest headaches. Do you have a loan from your sister and her husband? Do you hate the fact that you borrowed money to buy a new computer? Whichever debt bugs you most, pay it off first.
Tip
To learn more about the debt snowball and the various ways to use it, download this free spreadsheet from Vertex 42: http://tinyurl.com/v42-debt. (You can see a video demo of the spreadsheet at http://tinyurl.com/v42-video.)
Regardless of which order you use to destroy your debt, put as much money as possible toward this goal. Apply raises and windfalls (like tax refunds) directly to your bills. Sure, you'd rather spend that birthday check from grandma on a night out with your friends, but it'll do you more good if you use it to pay off that last night on the town. You'll have plenty of time to spend future windfalls; for now, use the money to get debt off your back.
And if someone tells you that you you're being stupid if you don't follow a debt-repayment plan that minimizes interest payments, just ignore him. The ultimate goal is to get your debts paid off. Know yourself and choose whichever method makes the most sense for you and your financial situation.
Tip
For the lowdown on the pros and cons of using home-equity loans to pay off credit card debt, head to this book's Missing CD page at www.missingmanuals.com.
You can do lots of other things to improve your situation while you're working on the three main steps of debt elimination. But all the debt-reduction tips you'll find are based on one simple fact: To pay off debt, save money, or accumulate wealth, you have to spend less than you earn—in other words, financial success comes from having a positive cash flow.
It's not always easy to find ways to earn more money, but almost everyone can find ways to curb their spending. Developing frugal habits is a great first step toward being debt-free. Some people think that frugal living is equivalent to being "cheap," but that's not the case. Frugality and thrift used to be core values in our society, but we lost touch with these ideals during the age of easy credit. Thrift can be a fun way to stretch your hard-earned dollars. (The next chapter discusses ways to be frugal.)
While you learn to spend less, do what you can to increase your income. Try selling some of the Stuff you bought when you got into debt. This can be painful, but ask yourself: Do you really use that weight bench? Is your DVD collection really doing you any good? Use eBay.com and Craigslist.org or the Amazon Marketplace to get some cash for the things you own. Consider taking an extra job or working longer hours. (For more on boosting your income, see Chapter 6, How to Make More Money.)
Finally, go to your public library and borrow a book on debt reduction. After you finish it, borrow another book about money. The more you learn about smart money management, the easier it'll be to make the right choices.
The most important thing is to start now. Not tomorrow, not next week—start tackling your debt now. Have patience and don't get discouraged if your efforts seem small and insignificant at first. Trust me: Most of us started paying off our debts the same way. In time, your efforts will bear fruit. If you're willing to persevere, you'll have your debt paid off sooner than you think.
Keeping your financial house in order is more important than ever. But how do you deal with expenses, debt, taxes, and retirement without getting overwhelmed? This book points the way. It's filled with the kind of practical guidance and sound insights that makes J.D. Roth's GetRichSlowly.org a critically acclaimed source of personal-finance advice.
