The most powerful force in the financial universe is compound interest, and if you are in debt, that force is working against you. Need proof? Grab a copy of all your bills and do this quick exercise to see how much interest you are paying on debt. The result will probably shock you and hopefully serve as motivation to learn how get out of debt once and for all! So let’s get started:
How to Get Out of Debt
The principle of getting out of debt is easy, but in practice, like becoming rich, it takes time and dedication. The basic principles of getting out of debt are:
- Recognize the debt problem
- Commit to getting out of debt
- Establish an emergency fund
- Accelerate debt payments
Recognize the Debt Problem
One of the most important aspects of making any lifestyle change is recognizing the need for change; this is especially true of habits that have become ingrained in our lifestyle. If you didn’t try that exercise linked in the first paragraph, I highly recommend it. Knowing how much interest you are paying will change the way you view debt.
Another powerful exercise is to complete a debt analysis which lists all your creditors, debt balance, interest rates, minimum payments, and how long it will take you to pay off the debt. Knowing and understanding the details of your debt situation is integral to this process.
Money Management Tip: Using money management or budgeting software can help you visualize this and make the job easier. You may find the following products helpful for your needs: Quicken, You Need a Budget, Mint.com, and free online money management tools.
Commit to Eliminating Debt
More important than recognizing the need for change is actually following through with it. This commitment can be broken down into two important steps: Stop using credit and start paying down your loans.
Stop Using Credit. Cut up your cards, freeze them, lock them in a safety deposit box, close accounts, or do whatever it takes to stop taking out more loans. Reevaluate planned purchases. For example, if you have a lot of consumer debt and were planning using a loan for a major purchase such as a new house or car, consider renting or buying an older model car with cash until you have eliminated your debt.
Start Paying your Loans. Make sure you are paying at least the minimum payment on all loans, otherwise you will be subjected to late fees, penalties, higher interest rates, and possibly a lower credit score. The ultimate goal is to accelerate debt payments and pay as much as possible above the minimum payment. But for now focus on being current on all loans.
Establish an Emergency Fund
What does saving money have to do with paying off debt? Everything. An emergency fund is an essential part of the commitment to no longer using credit because it gives you a cash on for unexpected expenses. Using your emergency fund instead of credit cards or other loans will help you get out of debt more quickly. It is a good idea to keep your emergency fund in an online savings account where you can receive high interest rates and maintain access to your money.
Accelerate Debt Payments
This is the step where we really start to gain ground on your debt elimination. Paying extra on your loans can help you save hundreds or even thousands of dollars compared to making minimum payments. In fact, the new credit card rules stipulate that credit card companies must disclose how long it will take to pay off your loans with minimum payments and what your payments should be to pay off credit card debt in 3 years.
Highest Interest Rate vs. Lowest Balance. There are two schools of thought regarding which debt to pay first, the highest interest rates or the smallest balance. Paying extra on the debt with the highest interest rate will save you the most money in the long run, but it may take longer to notice a difference when you are making multiple payments each month. Making additional payments on the loan with the lowest balance gives a psychological boost because you eliminate a credit card loan or other debt more quickly using this method. Both methods are successful, so use the method that you prefer.
Snowball Your Debt Payments. The debt snowball is a debt reduction method popularized by Dave Ramsey. Simply stated: Pay extra on your loans and when you eliminate one loan, add the amount you were paying to the next loan on your list and repeat. In this method, your payments “snowball” and you will eliminate your loans more quickly.
Advanced Debt Reduction Strategies
As you repay your loans you will probably notice that your credit score improves because you are making regular, on-time payments and your credit utilization decreases. If you have a good credit score, you can probably qualify for a 0% balance transfer card which allows you to transfer credit card debt to a 0% APR credit card. This is an advanced debt reduction strategy because it requires opening a new credit card. This should only be used if you are committed to getting gout of debt and will not use the credit card for new purchases. Another advanced debt reduction strategy is a do it yourself debt consolidation plan, which can reduce your interest rates and simplify the repayment process.