Getting Out of Debt
Two fundamental rules: don't get into any more debt,
and pay off your existing debt as quickly as possible.
[Note: The Saving Money and Using Money Wisely sections cover in more detail many of the concepts and terms used here. We strongly recommend you study these first.]
To begin with, It is important to understand clearly the meaning of “debt.”
A debt is an obligation that you need to pay, but that you don’t have to spend any further money on once it is paid off.
A car loan is a good example. It’s a debt because you have to pay it off (or risk losing the car), but once it’s paid off, you’re “free and clear” and don’t have to pay any more money on it. In fact, the same amount of money you previously had to spend on the car loan debt can now be used to pay off any remaining debts more quickly.
And once you’ve paid all your debts, you can start putting all the money you no longer owe into a savings account, certificate of deposit, or other type of investment that will build a nest egg for some important purpose later on.
One of the biggest and most troublesome kinds of debt is credit card debt. This is a major problem for two reasons:
- Having a credit card in your wallet is a very easy (too easy!) way to run up a very large debt for things you don’t really need (or that you should be paying cash for, such as clothes and groceries).
- The monthly interest rate on credit card balances is extremely high—12% to 18% or more. In addition, this interest is compounded, so you wind up paying interest on top of interest. These interest charges come straight out of your earnings, so instead of being able to use this money to buy food and clothing or pay the rent, the only thing you can do with it is help the credit card company get richer. Do you really want to work many hours a week for the credit card company?
The plan described below will help you get out of the “debtor” category and into the “saver” category. In other words, it will help you get to the point where banks or other institutions will be paying YOU interest, instead of the other way around.
Moving from "debtor" to "saver" may be very difficult for you if you've been following a pattern of debtor-type habits in the past. Signs of Compulsive Debting will help you determine if you're in this group and how much motivation and persistence will be needed to make the out-of-debt plan work for you.
You will need to:
- have a regular, ongoing monthly income (through steady employment and/or other regular payments)
- be willing and able to make—and follow—a carefully designed money use plan over an extended period of time.
Based on your current income, your money use plan must be designed for and sufficient to
- cover all your regular living expenses
- cover all your current debt payments (the minimum required amounts) and, in addition,
- put aside at least 10% of your total monthly income. You will use this to pay down your debt over and above the minimum payments the lender requires.
The steps below will help you apply this plan toward completely eliminating your debt.
You should first read and study the example given below. Then, apply the same process using your own financial information.
1. Let’s assume the person in the example (we'll call him Joe) has only two debts: a car loan and the balance on a credit card. (Note: If you haven't done so already, right now is the time to cut your credit card into little pieces and throw it away. This may be the most important single step in your own debt elimination program!)
2. For each debt, Joe determines the number of months it will take him to pay off that debt if he makes only the minimum required payment every month. He does this by dividing the current balance on the debt by the minimum monthly payment.
His current car loan balance is $2,000 and his monthly payment is $65. He therefore divides 2,000 by 65 to get 30.76 (round up to 31). This is the number of months it will take Joe to pay off the car loan. This same formula can be used to figure out the number-of-months-until-payoff for any other kind of debt that does NOT charge compound interest (interest on top of interest).
3. For Joe's credit card debt, determining the months-until-payoff is more complicated because of the compound interest he is being charged.
Let's assume that Joe's current card balance is $860, the card's interest rate is 16.5%, and his minimum monthly payment is $42.
Fortunately, there are computer programs that can do the months-until-payoff calculation for Joe (and for you). On a scrap of paper, write down Joe's card balance, interest rate, and regular monthly payment. Enter these numbers in the first three spaces of the calculator that will open when you click here.
The answer you get is 24 months.
4. Joe now compares the number-of-months-until-payoff for each of his two debts. The debt having the fewest months before it is paid off will be his first target for debt removal.
In this example, Joe's first target is the credit card at 24 months (versus 31 months for the car loan). He now attacks this first target by adding to his required monthly credit card payment the previously mentioned 10% of his net monthly income. ("Net monthly income" is the total amount that's left in the paycheck after all the automatic deductions, such as tax withholding, health insurance premium, etc. have been taken out.)
5. Let's assume that Joe's net monthly income is $1,200. Ten percent of $1,200 is $120. This is the additional amount he will add every month to his credit card payment to pay down his card balance faster. Joe's monthly payments for each of his two debts would be as follows:
- $65 for his regular minimum monthly car payment, which he of course still has to keep paying while he's attacking the credit card debt
- $162 for his credit card payment. This amount is the required $42 minimum payment, plus the additional $120 that is 10% of Joe's net monthly income.
6. At this point, a very good thing has happened. Joe has made approximately four times the minimum required payment on his credit card balance. If he keeps this up,
- he will pay off his entire credit card debt much sooner (in this example, in 6 months rather than 24 months)
- he will not have to pay the considerable additional interest he would be charged if he made only the minimum payment each month. This will leave Joe with even more money to pay off all of his debts faster.
7. As soon as Joe's first (credit card) debt has been paid off in full, he can now turn to the next debt to be eliminated. This next target will be whatever remaining debt has the shortest payoff period as determined in steps (2), (3), and (4). In Joe's case, this would be the car loan, which happens to be his only remaining debt.
8. Joe now attacks the car loan by paying on it every month the grand total of $227, which is specifically:
- $65 (the required minimum car payment ), plus
- $120 (10% of his net monthly income), plus
- $42. This is the original minimum payment amount on the credit card, which Joe no longer needs to pay and can easily switch to helping pay off the car loan!
Regularly paying $227 toward the car loan will not be a problem for Joe, because he has already gotten used to paying this same total amount in the form of debt payment while he still had both the car loan and the credit card debt.
Exercise: Make a list of your current debts (credit card, car loan, etc.) that you need to make monthly payments on. What is the approximate remaining balance on each? Which of these charge compound interest?
Applying the Plan to Your Own Situation
If it "fits" for you, the 8-step process described above--repeated in turn for each of your outstanding debts--will produce a snowball effect that will greatly shorten the time needed to pay off all your debts.
And once your total debt is zero, you can immediately start paying yourself (by depositing in a savings account or other interest-bearing investment) the same amount you were previously paying on your "no-longer-there" debts.
Once all your debt is gone, paying yourself first by putting a good amount of your income into savings (instead of spending this money for things you don't really need) will soon result in a quite large sum you can use for some major purpose in your overall life plan.
Some Important Notes and Thoughts
The debt elimination process described above is discussed in more detail in a book named Life or Debt, written by Stacy Johnson and published by Ballantine Books (2002). You can probably find it in your neighborhood library.
As previously stated, to succeed in this approach to debt elimination you will first need to have a steady income. In addition, you will also have to be very economical in the way you use money and highly motivated to follow a plan that will considerable effort over a rather long time.
To make a good decision about whether you’re in a position to use and succeed in the debt elimination plan, you should do all of the following:
- Determine the order in which your own debts should be attacked (following the steps described in this section)
- Determine whether you really can apply an additional 10% of your net monthly income toward reducing your debt
- Calculate the total dollar amount needed to start attacking your "number one" debt (including the additional 10%)
- Be sure you can also continue to make the minimum payment on your other debts, as well as cover your other living expenses on an ongoing basis.
If your calculations show you have a reasonable chance of successfully starting and continuing to follow the debt elimination program, we certainly suggest that you "go for it."
If you go through these steps and find you have more total debt than you will realistically be able to handle using the debt elimination approach, you can first try to negotiate with your creditors to forgive some of what you owe and/or arrange more favorable repayment terms.
If this still doesn’t result in a workable situation, you may want to consider filing for bankruptcy. This will allow you to “start over” with a cleaner financial slate, but will also require you to develop and follow a very conscientious and much better plan for how you will manage money in the future.
Before deciding to take such a step, you should discuss your situation with one or more people who specialize in bankruptcy and related financial matters and whom you can trust to give you their detailed and straightforward advice.