How to Get Out of Debt
One of the most critical issues facing people today is money management. Often times you learn how to manage your money when you are wondering how to get out of debt. While there are no easy answers to how to get out of debt and each persons situation is unique, most of the time how to get out of debt can be simplified to three easy steps.
How to get out of debt is not easy, nor is there a quick fix. But with some determination and a plan in place, you can get out of debt. It will take some time, but lets look at the three simple steps of how to get out of debt.
- Stop taking on additional debt
- Create an emergency fund
- Implement the debt snowball
Stop taking on additional debt
One of the biggest problems that we face is the use of credit. People rely upon credit too much. We have been taught from an early age that it is cool to have a credit card, easy to swipe because you don’t have to carry cash and you can pay it off at the end of the month.
Well, when the end of the month comes, are you truly able to pay it off? Chances are you can’t, that is why you are reading this.
Credit cards are a scam!
The first step you should take to get out of debt is to cut up your credit cards. Don’t just hide them, or take them out of your wallet or purse “for storage”, cut them up! This is the most crucial step you can take towards getting out of debt. If you don’t have a credit card, you can’t use it and will stop taking on additional debt from the credit cards.
Another step to stop taking on additional debt is to stop any non-essential services or bills. Get rid of the cable t.v., cancel the gym membership, stop eating out all the time. These might sound harsh, but if you were to track what you are spending your money on each month that could be going to paying off your debt, it would make you furious!
Once you have cut up your credit cards, you need to call each credit card company. They won’t close your account if it has a balance on it, that’s ok. Talk to them and ask for a better deal! Most of the time if they think you are going to take your business elsewhere, they will be willing to negotiate a lower interest rate for you. It never hurts to ask for a lower interest rate!
As for the other services that you have cut out, this is only temporary until you have reduced your debt to the point that you can then truly afford them.
Create an Emergency Fund
This step might sound a little strange, but hear me out on this.
One of the reasons that so many people feel it necessary to have a credit card is for those “just in case” times. You know, if your car were to break down, or the water heater goes out. If you are trying to get out of debt it sounds counter-productive to take some money and put into an emergency fund.
The emergency fund is not for things like going out to dinner or shopping for clothes. This is for true emergencies, like mentioned above. If your car blows a tire and you didn’t have the money for it, chances are you would put it on a credit card. Right? The water heater in your house goes out and you don’t get paid for another week, credit card. See the trend?
There are two types of emergency funds that most financial experts recommend. The short term emergency fund and the long term emergency fund. The long term emergency fund is often refered to as 3 to 6 months of living expenses. This is for if you are out of work or suffer an injury or other circumstance that you can’t control.
The short term emergency fund is what we are specifically looking at here. You want to immediately start towards saving $1,000. If you already have a good savings account balance, then you are well on your way. However, you don’t want this money to be mixed in with anything else, or tied up in any way.
Open another account at your bank for this emergency fund. Most banks will let you have sub-accounts, such as a christmas club or other special savings account. You want this money to be available and not tied up in a certificate of deposit or other fund. The $1,000 is minimum for your emergency fund. If you have at least $1,000 in a savings account, take $1,000 of it and put it in your emergency fund. Don’t touch this unless it is a true emergency.
If you don’t have any extra money, that’s fine also. Just start placing what ever you can in this emergency fund. Whether it is $5 per week or $50 per month, you must start someplace.
Sometimes the emergency fund will take some time to get going. It is better to have something there for when you need it, than rely on the credit cards that got you into the mess in the first place.
Implement the Debt Snowball
Now you might be wondering what I mean by the debt snowball. This is really an amazingly powerful debt reduction system.
Debt reduction and elimination is all about numbers. The whole basis of personal finance can be boiled down to one sentence:
You need to make more than you spend.
The debt snowball will help you to pay off your debts faster, and the results will shock you once it is going. Picture this, a small snowball at the top of a hill starts rolling downhill. As it gets further down the hill, it keeps growing larger. When it gets to the bottom of the hill, it is huge! This principle will guide you as you eliminate your debt. Let’s look at how it works.
The debt snowball works by taking all of your debts and placing them from lowest balance to highest balance. It doesn’t matter what they interest rate is, and we are not counting your mortgage for this (that is another step on down the road). You will work on paying off your lowest debt first and then taking that amount and putting it into the second debt and just keep rolling it until all debts are paid.
If you have three credit cards with the following balances for this example.
- Card A - balance $1000 - minimum monthly payment $100
- Card B - balance $2000 - minimum monthly payment $200
- Card C - balance $10,000 - minimum monthly payment $300
Now for the sake of really focusing on how the debt snowball works, I have used simple numbers.
So, you are now paying $600 per month on 3 credit cards. You have cut them up, reduced or eliminated non-essential services and are working on your emergency fund. At the end of the month you have an extra $200 after all bills and living expenses are budgeted.
You will take this extra $200 per month that you have, add it onto your $100 per month credit card, therefore making a $300 per month payment. Instead of it taking 10 months to pay off Card A, you will now have it paid off in a little more than 3 months.
Now, don’t think you just freed up $300 per month for play money! You’re not done yet!
Take the $300 per month that you were paying towards Card A and put that towards Card B. Since it has been 3 months, Card B balance is now $1400. So you will be paying the original $200 plus the $300 from Card A towards Card B. You will have this card paid off in less than 3 months! If you aren’t getting excited seeing how this works, just wait!
Your final card balance, since 6 months has gone by and you have made the minimum payment each month on it, is now $8,200. So, you have paid off $3,000 in credit card debt in 6 months. You now have $500 per month more that you can put with your $300 per month minimum payment on your largest debt. By paying $800 per month you will have this bill paid off in a little more than 8 months!
Now, with an additional $800 per month, do you think you can afford to create that emergency fund? How about paying off that car loan, or going after your mortgage?
The numbers I have used don’t take into consideration interest or other factors. I used them for a simple example on how the debt snowball works.
Just remember, the best way to get out of debt is to eliminate credit cards and stop taking on additional debt, save for that emergency, and utilize the debt snowball. You will learn how to get out of debt this way the fastest.