Common sense says in order to get out of debt, you need to spend less than you make; then use the extra money to pay down your debt.
Sounds easy enough, but knowing where to start can be challenging. While nobody likes to be in debt, there are cases where it's unavoidable. Home, car, and school loans are a few example of debt. These are source of debt you have had to incur to function in normal society. In reality it's okay to have debt as you get started in life. Just make sure you have a plan to tackle your debt.
Find where you stand with 28/36 Rule
The 28/36 Rule is the rule-of-thumb for calculating the amount of debt you owe. It is a common standard used by most lenders as one of the factors for approving a loan. The basic premise of the rule is that a household's housing expenses (home mortgage or rent) should not exceed 28% of its gross monthly income and no more than 36% on total debt service. The rest of the debt other than housing includes car loans, school loans, credit card, etc.
So when looking at your debt, the 28/36 rule is a good general guideline to get a baseline of where you stand. So for example, if you are living in a home that has a mortgage that exceeds 28% of your family gross income, you are living “too large” for your income. It's time to think about downsizing.
Is a Home a Good Debt?
Now of course no debt is preferable. Ideally you never have debt. But that is not realistic for most. With that said, generally a home mortgage with a good interest rate that does not exceed 28% of your total gross income is what I would call good debt. You can generally deduct the interest from your taxes. Plus, a home normally appreciates in value.
So assuming you are good on your housing expenses, read on to see my 5 tips to manage your debt.
STEP 1: Figure Out Your Total Debt
First you have to know where you stand financially. Just blindly paying bills as they arrive monthly is a bad strategy. You need to know the details of how much you own on each loan and the interest rate you are paying.
Examine your debt. Gather all statements for any outstanding debt including car loans, credit cards and any personal loans. Remember, do not add your home loan.
For each debt, you will want to record the following information:
- The current total amount due
- Interest rate
- The minimum payment due per month
Putting the list in a spreadsheet (like Excel) will help you visual the debt better, and allow you to total it all up electronically. You may also want to verify your debt by pulling your credit report, in case you feel like you're missing something.
Once you have all your debt recorded, total it up. Now if the number shocks you, do not be discouraged. This is your starting point, and from here on out, the goal is to chip away from this total.
Step 2: Lower Your Rates
Paying high interest rates on your loans will definitely slow down your ability to pay off your loans quickly.
Use Credit Card Balance Transfer Option. If you have good credit, you may be able to get an introductory 0% or very low rate credit card offer. Credit card companies will usually allow you to transfer your credit card debt to get your business. This method works if you are committed to paying off the credit card debt before the low rate offer ends.
Negotiate or Refinance You Loans. If you got a high rate car or student loan payments, sometimes you can negotiate the rate with your lender. Especially if the rates have come down since you initiated the loan. Often times they will be willing to do so to keep you as a customer.
Step 3: Decide Your Method to Pay Down Your Debt
Now there are two lines of thought when it comes to figuring out which order to pay down your debt. They are the debt snowball and debt avalanche methods.
Which is better? Well it depends, one is more of a psychological approach and one is more of a mathematical approach. The short answer is it depends on your personality. Let's take a look.
The Debt Snowball Method
The Debt Snowball approach involves you listing your debt totals from lowest to highest without accounting for the interest rate. The basic plan is that you pay over on your smallest loan, and continue to pay the minimum on the rest of your loans.
For example, let's say you had three loans as shown:
|Credit Card Loan||$5000||13.0%|
Using the Debt Snowball method you would pay as much as possible on your monthly payment for the car loan, while still paying the minimum on the credit card loan and student loan. So basically you have a snowball effect, since each month more money will be going towards the principal versus the interest for the car loan. Once the car loan is paid off then you can turn your attention to the credit card loan. Then finally pay off the student loan.
The snowball method is popular with some financial gurus like Dave Ramsey because the argument is that it motivates the individual paying down the debt to see a loan paid in full. Basically it gives you a sense of accomplishment, and the drive to keep going.
The Debt Avalanche Method
Now the main drawback to the snowball method is that you may end up taking longer to pay off your loans, since you will pay more interest over time. This is mainly because the debt snowball does not take into account the interest rates for each of the loans.
The debt avalanche method starts out similar to the snowball in that you pay over on one loan and make minimum payments on the others. However, this time you sort them in order of interest rate low to high, and not loan amount. So in the example above you would pay off your credit card loan first, then student loan, then car loan.
Now personally, I fall in the debt avalanche camp. To me it makes more sense to pay down the highest interest rate loans first, because in the long run you will be paying less interest on your loans.
Again there are merits for both ideas, and as I stated earlier, it just depends on your preference. If you want to cheer yourself on with milestones and get a quick win with the smallest loan, then go with the Snowball. If you are playing the numbers game, go with Avalanche.
Step 4: Create a Budget For Your Family
So in order to be able to pay over on the loans in step 2, you first need to figure out how much money can be spared from your monthly expenses. Basically, you are going to need to create a budget.
When creating your budget you must have a method for tracking all your expenses and earnings. I cover this concept of capturing all your earnings and expenses with apps like Mint or Personal Capital in my trim your budget post. That is what I recommend, but you can use what is most familiar to you for tracking it all.
Follow the steps below to create your budget.
- Calculate your total family income. This includes your salary, your spouse's salary, and any other sources of income you receive. This can be done automatically using the apps mentioned above. I recommend doing that.
- Calculate your total family expenses.
Calculate your fixed expenses. Start with your expenses like your home mortgage or rent, car and home insurance, minimums on existing credit card payments, etc. Basically these include all expenses that are fixed, and most likely going to be the same each month. You probably cannot do much with these, but still need to note since they will subtract from your income. Do not forget to include your minimums on all your debts for this category.
Calculate your variable expenses. Now these are expenses that might change from month to month. These are expenses like groceries, utilities, eating out, entertainment, etc. Your variable expenses will likely be the area where you can find some fluff, and be able to cut back a bit.
The goal is to set limits on the expenses in these categories to free up money for paying down debt. Two common ways to free up some funds are to save on groceries and cut down on eating out expenses.
- Adjust expenses and define amount you will allocate to paying off loans. Once you have all your expenses, then you need to adjust your habits. Basically you need to decide what and how you can trim from your variable expenses. Once you have an amount you can trim from your budget, you will then know how much you can allocate towards paying down your loan.
- Keep Re-adjusting. Things may come up from time to time, and the number you can allocate to paying down your loan can drift up or down. You may have an unexpected expense, or on the flip side you may get a raise or start a side hustle. The main thing is to be as consistent as possible, and if the situation does arise where you can allocate more money to tackle your loans, then do it!
Step 5: Pay Off Your Debt and Plan Ahead
So this last step is just a reminder to not quit, and keep going til all your debt, other than your home, is paid off. Now things might come up like having to buy a new car, but ideally once you get your debt under control, you want to minimize as much future debt as possible.
What you want is a situation where that extra money you had been using for debt can now start going to investing and building your wealth. You can also be more strategic and use multiple savings accounts to pay off those planned expenses. This is preferred over taking out a loan to do so. All of this is possible, once you are free of debt!
Do you have debt? What strategies worked for you to tackle your debt?