6 Simple Steps to Reduce Debt
Every time I sit down to write an article about investing, my gut tells me that I should focus my attention elsewhere. Most of the email we receive is from folks who are up to their eyeballs in debt and are ready to call it quits. Forget retirement. Forget saving for their kids’ education. They’re barely making ends meet thanks to their monthly debt-servicing bill. With this in mind I’ve decided to write down the steps I took to get out of debt. It can be argued that there are more than six steps, but these are the basics. Enough jabbering, let’s go.
Step 1: How much do you owe? Really.
Do you even know? Most people never realize they’re in trouble until they can’t make all their minimum payments in a given month. That’s not a situation you want to be faced with, so the first thing you’ve got to do is gather all your credit card, loan and mortgage statements. Actually, it’s up to you if you want to include your mortgage, but why not put everything on the table since we’re coming clean.
You need to list out the name of each card or bank, the interest rate charged, the outstanding loan amount and the minimum monthly payment. List them in order of highest interest rate to lowest interest rate. Total up the total amount you owe and the minimum monthly payments. Don’t worry about how much you owe. It’s been said that almost anyone can eliminate their debts within 5 to 7 years, including their mortgages. Yes, that includes you too.
Step 2: STOP SPENDING!!!
The reason I make this step #2 is obvious. If you’ve done what you’re supposed to do in step #1, you’ve had to come to terms with what your spending habits has done to your financial future. If you don’t stop spending you’ll just keep digging yourself deeper and deeper into debt and one day you’ll realize that you’ve been digging your own grave. Hopefully that day is today. Ugly picture, I know.
But don’t let that total debt number get you down. The main thing is that you’ve realized that you’ve got to change something and you’ve dedicated yourself to do something about it. So resolve to use your credit card only for essentials from now on and pay the balance at the end of the month. If you're in the market for some big ticket item like a sofa or a TV, resolve to save up for that purchase rather than buy something you currently cannot afford.
Step 3: What’s your cash flow?
This number is really important because you need to determine how much you can pay over the minimum required for all your debts. In the end, it’s up to you to decide how much of your extra cash flow will go toward debt repayment or investment. It all depends on what your goals are. My suggestion is to take a chunk of your extra cash (say around 50% to 70% of it) and put it toward debt repayment, if your debt has truly become a burden to you. This advice is much easier to give right now given today’s investment environment, but believe me; it wasn’t so easy three years ago.
What do you do with the rest of that free cash flow? Read on…
Step 4: Build your emergency fund
Before you invest or pay down any debt, check to see that you’ve set aside some money in an emergency fund. Three to six months after-tax living expenses in a money market account would be nice, but you can start investing if you have two months set aside, but have a definite plan to continue to add money to your fund over the next three months or so. Remember that your return on your emergency fund is less important than the fact that you have the money set aside and readily available for unforeseen expenses.
I’ve read too many articles that suggest you should pay the minimum on your debts until you fully fund your emergency fund. I understand why this advice is given, but I think that if you’ve got one month’s living expenses set aside, you should do double duty: fund your emergency fund and begin to pay more toward your debts. This way you’ll have enough money set aside in your emergency fund after a period of a few months and you’ll have paid down some of that expensive debt of yours.
Step 5: Consolidate/Transfer Debt
I’m betting you already know what I’m going to say, but I’ll say it anyway. I’m sure you’ve had your mailbox filled with enticing offers from credit card companies offering some pretty enticing introductory rates for their cards. Maybe you got them from some of your current cards that were too good to pass up. You know, those 0% balance transfers for the next year or life of the loan. Perhaps those very offers are the ones that got you in trouble in the first place. Or maybe you’re the type that endlessly transfers your balance from one card to the next in the hopes of escaping the interest monster.
Now’s the time to take advantage of those offers to find out:
- The cost of the transfer
- The length the interest rate will last
Check the fine print of any offer you get to see if the fees for the transfers are worth it. Most companies will charge you either 3% of the balance transferred up to a maximum of $40 or $50 (with a minimum fee of around $5).
Simple Math
Get a calculator and figure out if it makes sense to transfer your money. For instance, it makes no sense to transfer $2,000 from a 12% rate card to one offering 9% for six months. Why? Because you would be paying roughly $120 ($2,000 x 12% X .5 years) in interest over the next six months if you did nothing. If you transferred the balance, you would be paying a $50 dollar fee (if the maximum was $50 – assuming a 3% of balance charge which comes to $60) and interest of roughly $82 ($2,050 x 8% x .5 years) for a total of $132 in fees and interest charged. So saving 4 percentage points didn’t save you money and actually cost you more money. Ouch. Be smart. Do the math and figure it out before you transfer anything.
Obviously the above example doesn’t take into consideration that you would be making payments during the course of the six months, but that’s why I called it simple math.
You should also look into consolidating your loans through a mortgage refinancing if you are able to do so. This will help you get a lower interest rate and give you the added bonus of making part of your payments tax-deductible. Just be careful not to continue spending because your cards are now "freed up." Put your credit cards on ice and keep only the two cards with the lowest fixed rate. After all, you’ve been through so much, do you really want to fall back into the trappings of frivolous spending and debt accumulation?
Step 6: Pay off the highest rate card/loan first
You should pay the minimum plus any additional funds you’ve earmarked for debt repayment against the highest interest rate card/loan and pay only the minimum on the other cards/loans. In other words, pay off your high interest rate cards first, then when that's done, attack your next highest rate card/loan in the same manner. Why do it this way? Because this way guarantees that you pay the lowest total interest rate over the course of your DEBT REPAYMENT PLAN. The sheet tab titled "Max Min vs Low to High Balance" in the YOUR DEBT REPAYMENT STRATEGY will explain why this is the best option. Anyone who argues against this method must have FAILED math in first grade.
Don’t throw snowballs
No, I’m not talking about real snowballs. I’m talking about the method of debt repayment that a lot of gurus swear by, which involves paying all you can against the smallest debt*, then working your way up the ladder to the largest debt. This technique is good for you psychologically, but not so smart financially if that small loan balance doesn’t carry the highest interest rate. Why? Because while your hard-earned dollars are paying off the loan with the smallest debt, there’s another card or loan that’s charging you more interest.
If two cards have the same rate, put the additional money on the card with the smallest balance. This way it gets paid off faster and you can transfer balances to it...or put it on ice (ie, don't use it).
*Note: Of course "Snowballing" by definition doesn’t mean you pay the lowest rate card first, a lot of people interpret it this way and this is how I am referring to the method. Remember, you get a psychological benefit by paying down the smallest balance debt, but will always get a better mathematical (read: save more interest) if you pay our higher interest rate loans off first.
Conclusion
Obviously this was just a quick take on a method of paying down your existing debts. If you’re thinking of paying off a mortgage, you’d have to weigh the tax benefits you would lose from writing off the mortgage interest versus paying off a debt with a lower interest rate. That calculation is outside the scope of this article and is not the reason I wrote this article. I wrote it because I’ve seen too many people use debt in the wrong way. It’s time people changed their spending habits in order to use debt properly.
Debt is a form of leverage that has built countless fortunes for centuries, but if used improperly, it has the ability to destroy your financial future. If your current debt was not acquired to build up your asset base (asset is defined as something that will appreciate in value and throw off a positive cash flow*), then it is bleeding you of your hard-earned cash every month. It’s up to you whether you consider your home an asset or not. I’m not going to get into that debate. The main thing is to whittle your bad debt load down so that you can use the money you once were using for debt repayment and redirect it toward acquiring some real assets or building a business. That should be the end state and reason for going through this debt repayment plan: funding your financial freedom plan!
As Robert Kiyosaki, my favorite author on financial wealthbuilding said, in his best selling book series, Rich Dad Poor Dad and Cashflow Quadrant, you need to Mind your Own Business. Guess it is time to really begin doing this,huh?
Now go get your credit card and other loan statements and begin putting this plan into action.
Be Prosperous!
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