It is easy for personal debts to spiral out of control. Consumer lending is big business, and there is a lot of pressure from banks and lenders to take on lines of credit. Once you take on the debt, paying it off just gets harder and harder, as the balances rise every month. We are good at ignoring problems in our life, but if we ignore our debts, the problems are guaranteed to get worse.
There are a few steps that you will have to take when you begin to get your debt under control. None of these changes are likely to be easy, as you will have to make major changes to how you spend and live your life. It might seem like a difficult task to make changes, but you have to do so, as your current life path will only become more unsustainable.
We will talk about a few things in this article, and you will need to think about how you can apply each step to your life. The first thing you need to do when debt gets out of control is to create surplus income, which means learning to slash spending. Unless you are considering bankruptcy as your debt solution, there are going to be some big changes in how you spend and save.
Dealing With Debt – Time to Start Saving
As we mentioned above, you will need to have extra money every month to make a dent in your debts. If you are already creating a big monthly surplus, and just want to learn more about debt payment strategies, feel free to skip this section. However, if you are going into debt because you can’t stop spending, you need to stick around.
Lots of people have problems with spending. Credit cards make it easy to spend a bundle of money and worry about where it went at the end of the month. There are a few things we need in this life, but the vast majority of what we buy are luxury purchases.
Let’s start with a shortlist of what you really need to survive:
If you want to get picky, we also need access to medical care from time to time, and most of us would go crazy without some leisure activities. All that said, anyone who has unmanageable debts shouldn’t be putting fun first, as they have some big personal challenges to address.
Where is Your Money Going?
One of the first things you need to do is figure out how much money you have coming in every month, and where it is going. If you have run up big debts, you are spending more than you make. Some debts are okay in certain instances, like a mortgage or car loan, but other forms of debt aren’t going to do you any favors from a financial point of view.
Start by making a list of all your income. If you have a regular job, this should be pretty easy. If you are self-employed, just take your average earnings for the past two years, and average them to get a ‘monthly income’. Once you have this figure, it will be much easier to see where your money is being spent, and how you can save more every month.
Common Places People Overspend
There are a few ways to track your spending. If you use a credit or debit card, just look through your monthly statement, and see where the money is going. If you deal with cash, you can start making a spending journal. Just write down where your money is spent every day, and after a few weeks, you should know a lot more about your spending habits.
One of the biggest things that people spend too much on is food. Eating out, or buying a coffee on the way to work might seem harmless, but it adds up fast. Spending $5 per day on a coffee six days a week adds up to $120 per month, which you could be putting towards paying down your debts.
Saving money is at the core of the FIRE movement (Financial Independence Retire Early), and most of the savings and lifestyle techniques that work for early retirement can also help you to build up a massive monthly surplus, which can then be used to pay down debts. Once the debts are gone, you will be in a much better position to become financially independent as well!
How to Pay Down Debts
Ok…so now we are going to assume that you cut the fat, and you have a big monthly income surplus to use for debt repayment.
There are two kinds of debt that consumers tend to use. It is important to know the difference, as one will probably be more important to pay off quicker than the other.
Revolving debt can be used at any time, and can generally be held forever, as long as a minimum payment is made on a monthly basis. Almost every credit card is a form of revolving debt, as you can use a predetermined amount of credit when you like, and then carry that debt forever, as long as you make the minimum monthly payment.
Installment debt is usually created for a specific purpose like to buy a home or car. The amount of the loan is fixed when it is created, and it must be paid off in installments, generally every month. The interest rate on installment debt is generally fixed, although some forms of installment debt can have variable interest rates.
Regardless of the kind of debt, you are probably making monthly payments. In general installment, debt is more likely to have a lower interest rate, as installment debt is used for secured loans, such as a mortgage, or subsidized loans, like student lending. Revolving debt is more likely to be unsecured debt, which carries a higher interest rate.
Clearly, you will want to target the debt with higher interest rates first, and then deal with any other debts you might have built up.
Getting Your Debt Under Control
Once you have built up a monthly surplus of cash, you will want to identify which debts are the most expensive to service and start paying them down right away. There are a few different ways to do this. Let’s have a look at a few techniques that you can use to get rid of your debts.
The avalanche technique requires that you make all of the minimum payments on your debt, and then put any additional funds at the highest cost debt you have.
For example, if you have a small debt with a high-interest rate, you would want to pay that debt off completely before you move on to the next lowest debt. As your debts are paid down, the additional money you have will go further every month, and as you near the end of your repayments, the lowest interest debts will be wiped out quickly.
Keep in mind that there can be tax benefits to some kinds of debt, like a mortgage, so be sure to talk to a tax professional before you wipe out all your debts with the avalanche technique.
The Snowball Method
Being in debt can seem hopeless, but the snowball method of debt repayment can help you feel like you are making progress. Instead of taking on the most expensive interest rates, you will set your sights on the smallest debts you have by dollar value, and pay them off first.
Form a financial standpoint, this isn’t the most effective strategy. On the other hand, psychologically speaking, the snowball method makes a lot of sense.
Once you start to see your debts disappear, it will be much easier to keep on the path to financial freedom, and you might even find other ways to save more money for debt repayments. Feeling like a success is a big part of making positive choices, and the snowball method gives you real-world results that you can be proud of!
Taking on more debts to pay off debts might seem like robbing Peter to pay Paul, but if Paul is willing to loan money at much lower rates than Peter, it makes a lot of sense to take on new debts so that Peter isn’t bleeding you dry with high-interest rate loans.
Debt consolidation is a blanket term for taking high-interest debts and paying them off with lower interest loans. There are many ways to use debt consolidation to make big changes happen in your financial life, and it is one of the best ways to save a lot of money over time.
Let’s say that you have multiple debts that add up to $20,000, and you are paying an average of 25% annual interest on it. If you can find a way to take that interest rate down to 10% per year, you just saved $3,000 on an annual basis.
All that extra cash can go toward paying off that debt and getting you back on your feet financially. The downside to debt consolidation is finding lower interest rate loans, as many borrowers who have debt problems will also have a poor credit rating.
Debt consolidation is a potential solution if you are a homeowner, and you have some equity built up in your house. Replacing unsecured high-interest debt with a home equity loan could be a great way to save loads of money, as long as you have made healthy changes to your spending patterns.
Make sure you are generating a monthly surplus before you tap a low-interest loan and consolidate your debt, so you don’t wipe out your ability to recover from your borrowing binge.