If I’m honest, I was quite pleased with myself about this time 10 years ago. I had just finished grad school, gotten a job, and purchased a new condo in the big city.
Life was good.
For me, it was particularly sweet that I had gone from a directionless undergrad with poor job prospects thru a complete career makeover in grad school to having at least a couple of decent career choices laid out in front of me.
So, to celebrate, I bought a new car and a new condo, completely on credit. And while owning both of those things was fun, the debt that I accumulated was not so much fun. And in addition, I still had thousands of dollars in student loan debt left over from grad school.
To make a long story short, about a year later reality started to set in. The condo was nice, but the real estate market had soured and I was now heavily underwater. The shiny new sports car’s allure had started to fade, and once I was forced to buy new brakes and tires for triple what they should cost for a “normal” car, it really started to lose its luster.
And my new job in the financial industry? Well, while it had provided a steady income so far, the business was struggling through the depths of the Great Recession, and of course, being the last one hired meant that I would probably also be the first one to be let go. So needless to say, I spent those years working my tail off to become “indispensable” as much as possible. Thankfully, I was able to hold on by the skin of my teeth.
The bottom line was that I was precariously close to financial ruin, and I knew just enough to be aware of it.
Debt Can Destroy Your Ability to Build Wealth
See, that’s the thing about debt. Granted, I’m not one of those people who thinks that all debt is bad. (In fact, I recently wrote a post all on this subject — how there’s a difference between “good” debt and “bad” debt.) But the reality is that all debt increases risk. (That concept is known as “leverage” in the financial world. It means that debt can act as a lever — increasing returns when times are good, but also increasing losses when times are bad.) Anyway, in the real world it just means that most of the time debt is bad and should be avoided, if possible.
Have you ever sat down with a debt interest calculator and figured out how much you are actually paying in interest? It is sickening to think about. All of that money could be working for you, instead of against you. It could be compounding interest as your investment, not as the bank’s profit.
But you have to get out of debt first for that to happen.
So let me tell you a few tips that helped me do exactly that. Oh and by the way, in case you are wondering, I had a very “normal” salary during this period. So don’t think that you have to be earning six-figures to get out of debt. Anyone can do it with a little bit of grit, determination, and a plan.
Tip 1 — Take an Inventory of Your Debt
What gets measured, gets managed. –Peter Drucker
First things first, you need to know exactly how much you owe, to whom you owe it, and what the terms are. That means it’s time to take an inventory of your debt to really get a handle on it. You can’t come up with a plan to get out of debt unless you first take a hard look at where you are.
For a lot of people, this is where they get stuck. Taking stock of their situation is painful, because it brings up bad memories and experiences that perhaps got them in this situation to begin with.
I get that. I mean, for some people like me, they got into debt just because they wanted to have things before they had saved up the money to buy them. (You know, with that thing called “cash.”) 😉
But for other people, they have debt because they lost a job, got sick or had an accident leading to unexpected medical bills. Or, maybe they had a former spouse or partner run up their credit cards behind their backs.
And so confronting the debt means confronting the pain for these people. If that’s your situation, there is no sugar-coating it, you’ve got it tough.
However, even if that is you, I still think you need to take stock of your debt, because in addition to the financial benefits, facing your past experiences and giving yourself time and space to grieve over those things is as vital to your emotional health as much as your financial.
So, whip out that spreadsheet/notepad/Word doc, and take stock of what you owe. Be sure to include:
- Creditor (who you owe)
- Interest rate
- Fixed or variable?
- Amortizing? (does each payment include principal so that the debt goes down automatically?)
Once this is done, you can go on to step two.
Tip 2 — Map Out a Plan of Action
There are two schools of thought on how to payoff debt. The first, recommended by most financial experts, is to rank your debt by interest rate, highest to lowest, and concentrate your efforts on paying off the highest interest debt first.
So this means you pay the minimum payment on all the debt except the one with the highest interest rate, and your throw all of your disposable income towards that one, until it is paid off.
This is obviously the “correct” method from a financial perspective, because the interest rate on each debt is the cost of that debt to you. Like a price tag at the mall, the interest rate is simply the price of money. The higher the rate, the more that debt costs you. So, obviously, you want to pay the higher interest debt off first.
However, financial guru Dave Ramsey recommends another tactic called the “Debt Snowball.” Basically, his advice is to rank your debt from smallest balance to the largest balance, and focus on paying off the smallest balance first. When that one is paid off (often within a few months), you focus all your freed up income on the next smallest balance, until it is paid off.
You continue this way until the largest debt is also paid off.
The benefit of this method is psychological more than financial. However, don’t discount the power of progress and forward momentum. You are not a computer, and chances are that you will eventually weaken in your motivation at some point. So this strategy helps by providing a little “shot in the arm” every time you pay off another loan.
Tip 3 — Get Rid of That Car Payment
Maybe you are thinking: “Well, this sounds great and all, but I’m already deep in the whole and getting deeper every month. How do I create enough room in my budget to even start paying down debt at all?”
Ok then, here’s a tip that can free up a lot of room in your budget right away.
One of the things that almost all Americans can do to create excess cash-flow is to get rid of that massive car payment. According to Experian, the average American’s loan for a new car is now almost $500/month. That’s an enormous amount of money to pay for a car, and when you run the numbers, it can cost you millions both in interest paid and lost investment gains that you could have made if you invested the money instead. (Check out my last post on “lifestyle choices” that can destroy your wealth for more.)
In my case, once I realized how much that sportscar was really costing me, I sold it and bought a much more economical car for cash. It was one of the best decisions I’ve ever made.
Not only did I now have an extra $300/month in my budget, but I also could start paying down the student loans as well. So now I had more cash-flow and I was reducing the future interest I would pay. Talk about a win-win!
Tip 4 — Refinance Your Debt
Many people don’t know that they can often refinance their debt to lower the interest rate, reduce their payments, or both. Interest rates have come down significantly in recent years, so if you have debt at fixed rates that are higher than the market, you might want to consider refinancing.
Even if you have poor credit, you may still be able to refinance. Recently, new companies have emerged that look at more than just a simple credit score to approve you for a loan. For example, a company called SoFi looks at your education, your job history, and other factors in addition to your credit score. And their rates are some of the most competitive out there.
Check it out at sofi.com and take 5 minutes to see what kind of rate they can get for you.
Tip 5 — Track Your Progress
One of the most important things you can do to motivate yourself along the journey is to track your progress. Especially if you are following the Dave Ramsey debt snowball approach, it can be a huge psychological reward every time you pay something off. I encourage people to have a little “mini-celebration” when that happens. Without blowing your budget, treat yourself to something nice that you wouldn’t normally do.
There are many apps and websites that can help you track your debt. From the old staples such as Mint.com to newcomers like Personal Capital, find a solution that works for you and use it regularly. Both of those are essentially websites that help you track your net worth as a whole by downloading data from your financial companies (banks, credit card companies, and investments) and integrating it into a holistic picture of your financial situation.
There is another solution that can help with specifically paying off debt, which I really like. It’s called Credit Karma, and basically they track your debt and your credit, and based on your situation they can help recommend other products as well.
And the best part? All of the above solutions are 100% free!
Tip 6 — Pay Your Debt First Before Anything Else
I can’t emphasize this final tip enough. I am not a big budgeter. I don’t spend hours and hours every month tracking every penny I spend. Maybe I should, but it’s just not my style.
Instead, I follow something I call the Anti-Budget, which simply says that you allocate your dollars towards the most important priorities first, and then figure out how to live on the remainder. It works for me, but I understand that it’s not necessarily for everyone.
However, whether you use the Anti-Budget or not, you can still setup your automatic payments to your debts to come out of your paycheck first before anything else happens. Some people even go so far as to have their payroll department split the payment directly out of their check, before it ever hits their checking account.
Do whatever works for you, but the fact of the matter is that if you have to make a conscious decision to pay off your debt at the end of each month after you’ve already paid for everything else, it probably won’t happen.
Well, this is my story of how I got out of debt, but I’d love to hear about your experience as well. Got any great “debt freedom” stories to share? Enter them in the comments below, and let’s help each other make progress together!