The economy is improving; people are feeling better about their finances; and as a result consumer debt is again on the rise. One of the greatest inhibitors to creating financial success and financial freedom is too much debt. Developing a plan to get out of debt is overwhelming for a lot of people so I’ve simplified it into three easy steps:
Step 1. Stop borrowing. Getting out of debt starts with a mindset that you’ve had enough and you’re ready to do whatever it takes to solve your debt problem. In a world where we are constantly bombarded with messaging that strongly suggests, “You can have your heart’s desire right now…just charge it”, makes it challenging to exercise “delayed gratification”. But this is exactly what must happen if you are going to become debt free. You must commit to NOT creating any new debt.
Step 2. Get organized. Gather the most recent statements for all of your debts and list each of them on a piece of paper (or spreadsheet) starting with the one with the highest interest rate. Your column heads will include: who you owe; interest rate being charged; current balance (total that you owe that merchant); and your minimum payment. For example, let’s assume you have seven creditors with interest rates being charged from a high of 21% to a low of 4%. The top of your list will be the 21% creditor and the 4% creditor will be on the bottom of your list. Let’s also assume that when we add up all of your minimum payments, the total is $1,700 per month. Finally, let’s assume that you know you can pay both the minimum payments plus an extra $300 per month.
Step 3. Execute your plan. You are going to pay the minimum on all debts except the number one on your list. Let’s assume that the minimum payment for this one is $200 per month. For that one, you’ll pay the minimum plus $300 for a total of $500 per month. Once that one is paid off, you’ll take the $500 that is now freed up and add it to the minimum payment for what was the number two item on your debt list. Every time a debt is paid off, that payment is applied to the next item on your list. In other words, you’ll always be paying $2,000 per month in our example until you are debt free!
By following this strategy, you’ll be surprised at how quickly you’ll become debt free. You can accelerate this plan by taking half of any pay raises and adding them to your ‘extra’ payments. Also consider taking half of any bonus and use it as one-time extra payment.
I’m often asked if the home mortgage should be included in this plan and while there are some tax benefits associated with home mortgages, I believe the psychological benefits of being totally debt free trump tax benefits in most cases.
One final thought. Once you are debt free, what do you suppose I’d recommend you do with your new-found cash flow? Invest it for your retirement or other financial priorities!