Frugal Living Series Week 2: Getting out of debt
Posted February 14, 2014
Updated March 3, 2014
In week 2 of our Frugal Living series, we are talking about debt – specifically, how to get out and stay out of debt. Are you struggling with credit card debt, student loans, medical bills or car loans? Do you wonder if they will ever be paid in full? You are not alone. According to indexcreditcards.com, the average American household has nearly $8,000 in credit card debt. This number doesn’t even include car loans, student loads, home mortgages, second mortgages or any other debt.
Let’s look at $8,000 in debt up close and personal. If you make a payment of $150 per month on an $8,000 balance with 11% interest, it will take you just over 6 years to pay it off. The total cost that you will have paid in those 6.16 years is $11,100. This means that you paid an extra $3,100 to carry that debt. By the time you paid it off, 6 years later, you probably wouldn’t even remember half the stuff you spent that $8,000 to buy. I am sure you would have preferred to have that extra $3,100 vs. paying it in interest fees.
Thankfully, there are steps that you can take starting right now that will get you closer to debt-free living every day. I am not going to tell you that it is easy to dig out of debt. It isn’t. My husband and I lived in a small home on a busy street for many years after we were married so I could pay off my student loans and credit card debt. We waited to have kids and buy a larger home until the debt was gone. Now, 19 years into our marriage, we continue to be debt free, other than our mortgage. I know what it is like to make sacrifices in order to pay off debt and stay out of debt and those sacrifices have been worth more than I can put into words. If you are in debt, you will need to make those same adjustments to get out of debt and you will be so glad you did.
Step 1: Determine Your Debt-to-Income Ratio
The debt-to-income ratio is an effective way to compare your debt burden to your total income. It is also one of the leading indicators of financial health used by lenders to determine creditworthiness. To calculate your debt-to-income ratio, add all your minimum monthly debt payments and divide the total by your net (after-tax) monthly income. The monthly minimum debt payments include mortgage, rent, credit card bills, car payments, student loans, child support payments and any other loans you may have. Do not include food, entertainment and utility bills when calculating your debt-to-income ratio.
Minimum Monthly Debt Payments divided by Net Monthly Income = Debt-to-Income Ratio
A debt-to-income ratio of .36 (36%) or less generally indicates stronger fiscal health. A ratio of over .36 is cause for concern and must be lowered through debt reduction. When your debt-to-income ratio is high, an unexpected debt, such as a medical bill or job loss, could mean financial disaster for your family.
Step 2: Complete the Debt Payment Worksheet
In order to track your debt and clearly see which balances need to be paid first, second, third, etc, you need to complete the debt payment worksheet found at the link above. Click the link and print out the worksheet. Gather your credit card bills and any other statements you have for other debt so know how much you are paying each month, what the interest rates are on the debt and the total balance for each debt. Fill out the form completely.
In order to determine the payoff dates for your debt, use the Bankrate.com calculator HERE at the link above. You will need to enter the credit card balance, the interest rate and the payment amount per month. It’s a real eye opener to see how long it takes to pay off debt when you only pay the monthly minimum.
Step 3: Pay Them Off – One at a Time
Once you know how many debts you have and what the interest is on each debt, it’s time to start paying them off aggressively. There are different schools of thought on how to do this. Most finance people agree that paying the mortgage off last is a good call since those rates are usually so much lower than credit card interest rates. But, when it comes to paying off credit cards and other debts, financial gurus differ in their recommended methods.
Most will tell you to start with the debt that has the highest interest rate and put everything you can toward paying it off asap. Once it’s paid off, put the amount you were paying on that debt and add it to the minimum you are paying on the debt with the next highest rate until that debt is gone. Then take the money that went to paying the first 2 debts and apply it to the next one and so on until all the debts are paid. That happens to be my recommendation as well.
Another popular debt-free advisor, Dave Ramsey at daveramsey.com recommends paying the debt with the smallest dollar amount first so you have the psychological win of getting rid of one of the debts as quickly as possible. He then has you do the same “snowball effect” using the total dollar amount of each debt to dictate order vs. the interest rates. I have to disagree on this one because you end up spending more money in the long run if you are paying more interest on your debts. But, with that said, his program has helped tons of people get out of debt rather quickly using serious discipline and determination (which I do agree with). His get out of debt workshops (Financial Peace University) are taught at churches around the country and if you struggling with debt, his program can probably help you. You can check out his books for free at most public libraries.
Step 4: Stay Motivated
Paying off debt does not happen overnight. Depending on your debt load, it can be a long process taking many years. Celebrate every time you pay off a debt. Have a picnic in your favorite park or rent that movie (at the Redbox kiosk) you have been wanting to see. If it helps to see your progress as you pay off debt, post your Debt Payment Worksheet on the fridge or on the bathroom mirror – whatever works to keep you focused.
Additional tips to consider when paying off debt:
• DO NOT continue to incur more debt. Cut up your credit cards or freeze them in a block of ice and do whatever it takes to keep you from using them.
• Keep in mind that you still need an emergency fund of at least $1000 so you don’t incur more debt when the car breaks down, for example.
• Take a cold, hard look at how you are spending your hard-earned money. If you are struggling with debt, it is time to seriously reduce unnecessary expenses like restaurant meals, new clothes, expensive grocery items like premium cuts of steak, cable TV, smart phones and vacations until you make a huge dent in that debt. You don’t have to give up everything you enjoy, but you do need to make some significant changes. Switching out a cable bill of $80 per month for an $8 per month Netflix subscription saves you $72 per month. That's $864 per year you can save with just one change!
• Sell items in your home that you no longer use and apply the money towards your debt. A great place to list these items is www.craigslist.org . Not only are you helping to get rid of your debt, you are also getting rid of clutter.
• Ask for help if you need it. You can contact your creditors, explain your situation and that you want to pay off all your debt in a timely manner. Ask for a lower interest rate and hopefully they will oblige.
• Call a non-profit credit-counseling agency that does not have a vested interest in making money off of your debt. A good resource to start with if you need credit counseling is the National Foundation for Credit Counseling (NFCC) at is http://www.nfcc.org and toll free at 1-800-388-2227. The NFCC is a well-known non-profit agency that helps individuals with budgeting and debt reduction plans. Many of the services are free or cost only a minimal fee.
The key to getting debt-free is to start today. The steps you take now will help secure your future and give you a level of financial freedom you never thought was possible. I would love to hear about the steps you have taken to pay off debt and stay out of debt. Please share them!
As I always say, it’s your money – spend it wisely!