Many Americans are in debt. Car loans, credit cards and student loans are the three most common offenders that linger in many family budgets. If you find yourself in this situation, you are not alone. Many American households are currently living paycheck to paycheck with no end in sight. This amount of debt is unacceptable in the world’s richest country. Something has to change as people continue to slip further in debt and their children watch and learn these bad behaviors.
Good spending habits are easy to explain. Do not spend more money than you earn. This allows you to keep debt at bay and out of your life. Many people probably would not own a car if there were no such process as a car loan. We have taught ourselves that borrowing money is the only way to survive. When we discuss loans, many people say that they have no problem with taking on multiple loans to fund their lifestyle. This contradicts the idea of spending less than you earn. Just because you can incrementally pay for an item along with the interest does not mean you can afford the item. You are essentially renting the item from the lender and you paying them for assuming the risk of loaning you money. This makes them rich while you continue to stay in debt.
People with good spending habits do not borrow money, they save what they earn, then make decisions to write checks for things that fit into their budget. This philosophy allows even the most modest earner to save for a long retirement. Think how much money you could save if you had no loans to repay to a lender, even including your mortgage. Once you achieve financial freedom, you can begin saving for retirement very quickly because the portion of your budget previously reserved for loan repayments can now go towards investment accounts, which helps you get ahead.
Over the past 20 years, I have developed a simple but effective plan that eliminates debt in a six-step approach that allows you to take over your spending habits and focus on debt elimination. If followed correctly, you should be able to eliminate the majority of your debt excluding your mortgage well within 30 months. This is not a very long time considering the average car loan is for over 48 months.
Step 1 is to build a budget. This sounds easy but many people have not sat down and built a budget to explain where every dollar they make is spent. In fact, if you were to ask a few people what their total monthly expenses amount to, they would probably have to begin by writing it on paper. Every household needs to follow a strict budget that is transparent and enforced. I bet the company you work for has a budget. I also bet your employer knows how much their monthly expenses are. This is because they do not want to default on any payments and your household should be ran the same way. Take the 30 minutes and write out an itemized budget.
Building your budget achieves three main goals. First, it enables you to see where you are spending money, which makes it easy to make some sound financial decisions. Next, it allows you and your spouse, if you have one, to be on the same page so you understand each other’s spending habits. This is important, you and your partner must financially unite or none of the other steps will work. Lastly, it tells you exactly how much money you have leaving your household. This information is very important leading into step 2.
Part of putting together your budget also includes eliminating extra expenses or at least putting some on hold. One that many may find difficult is the retirement accounts contribution elimination. Do not worry; this is only a temporary situation. Once everything but your home loan is paid, you will continue to contribute to your retirement accounts. It may seem risky especially if you have only a small nest egg but overall stopping these contributions allows you to throw more money at your debt, which ends the debt faster so you can contribute more to retirement later. If you were previously contributing $300 to an IRA with $30,000 in debt, after you pay off the debt, you can bump up the IRA contribution and max it out.
There are many ways to distribute the money in a monthly budget, which I will talk about later but here are a couple quick notes. Some rely on the 50, 30, 20 rule. This means to allot 50% of your budget to fixed payments such as car and home loans. The 30% goes to variable payments such as electricity and groceries and the last 20% would go to savings and investments. This strategy does not meet every household’s goals, especially when trying to pay down debt so I recommend that the numbers not be addressed until you are out of debt, excluding your mortgage. This allows you to set realistic expectations for your debt reduction timeline. Only after you have paid all the debt except the mortgage, should you use any percentage rules.
Step 2a is to create a small starter savings fund that is only for emergencies such as the car breaking down or you missing a day of work because you are sick. Different financial advisors recommend different standard amounts but I believe one set amount is not safe for every situation as some have more people in their household, which equals more liability. The numbers I recommend are $1,000 for singles, $1,500 for married and no children, then $2,000 for married with children. Again, this fund is only for unplanned events and anything outside of this small fund will have to come from the monthly budget. For many households, this alone might take a few months to build but stick with it because it is important to establish a financial buffer prior to step 3.
Step 2b is to grow and expand your income, if possible. Services like Uber and Lyft allow people to earn additional money with very little additional effort. You could also deliver pizzas, walk dogs, mow lawns or babysit in your spare time. Regardless of what you decide to do, the math tells us the more income you create, the more you can attack your debt. Filling your spare time with additional jobs makes it easier to disconnect the cable television service and lose that $150 a month bill.
Step 2c tells people that if any bills have gone to a collection agency, it is your responsibility to settle those debts and put them into your step 3, if not they will continue to haunt you and your credit score. While calling these agencies, you should know exactly what the debt was prior to any late fees. This will be your advantage when negotiating a payoff. I have seen an original $400 bill go over $900 after additional fees were added. The collection agencies buy those default accounts and try to collect whatever they can to earn a profit. If you give them $900, they will be ecstatic but you would have wasted your money. Begin the conversation by asking them the best offer to settle the bill. They will probably drop to what you originally owed but that is not their best offer. Kindly tell them you do not have that much and offer them one quarter of what you owe them. They may or may not accept it but just realize you can definitely negotiate the payoff. Also, ensure you request a signed letter stating the amount negotiated will clear the debt before you send any money. If possible, send by money order so they do not have access to your bank accounts.
Step 3 is what many people refer to as the debt snowball or sometimes the debt avalanche. You take all the debts, put them in order of lowest to highest total amount owed, and pay them off in that fashion. While doing this step, you pay only the minimums on the other higher debts and throw all additional money beyond your monthly budget at the smallest debt. I do recommend this method but I also want to save you as much money as possible so I throw a twist into this typical strategy. I also recommend mixing in what is called the laddering method. For any high interest loans, such as credit cards, payday loans or anything above the 10% range, I pay those off by highest interest rate first. This saves additional money because you avoid letting the high interest rates to linger. If you let them stay while only paying minimums it could cost you hundreds of dollars in interest. Take this example; you have a $25,000 student loan at 3% interest, a $8,000 personal loan at 9%, a $9,300 credit card loan at 28% and a $6,000 car loan at 5%. The snowball method tells you to do the car, the personal loan, the credit card and then the student loan. This will work just fine however; you will continue to pay a very high interest credit card payment, which will cost you more money because your minimum payment is probably not covering the interest that is gaining on the principal. I would recommend you attack the highest interest in this situation then revert to the snowball method. Remember; only attack the high interest items, typically credit cards and payday loans in this fashion, then continue the debt snowball method. Therefore, this example will have you pay the credit card first then the car, the personal loan, and finally the student loan.