Tips to Clear Your Debt and Get Your Finances in Order
So you've got a debt problem. Now it's affecting your lifestyle.
As debt grows, paying the interest becomes a bigger portion of your paychecks until you are just working to pay back your debts.
With your debts out of whack, you will never qualify for loans, save for retirement, or help your kids pay for college.
So here's the thing - you don't have a debt problem, you have a spending problem.
The majority of indebted people are solidly middle-class or higher. So, if you are in a lot of debt it is likely due to your spending and not your income. More likely than not, you need to adjust your lifestyle.
Clearing Debt Requires Lifestyle Adjustment
What got you into this problem in the first place is your willingness to buy things you can't afford or don't need. It's fine to have flashy toys and new things, but only if you can afford them.
Once you pay off your debt, you are likely to just do it again if you don't make permanent changes to your lifestyle. Here are a few quick and easy changes.
Ask Before You Buy
Before I buy things, I always ask myself - "Do I want this or do I need this?"
If it's a necessity, then I never hesitate to buy it. If I want it, then I decide if I want to pay for it or not. Simply by pausing to ask this question, we have easily cut thousands of dollars in expenses a year.
By pausing for just one second, it eliminates all impulse purchases.
Never Make a Big Purchase in 1 Day
Never find the product and purchase it in the same day.
If there is something that you need then shop around for it and always think about it for at least one day.
Never fall for 'today only' sales tricks. If that store doesn't have it on sale tomorrow, you could probably purchase it online for the same price or cheaper anyhow.
By giving yourself a night to think about it, you may think of alternatives, find a better deal, or even just decide you don't need it after all.
Clear debt by Creating a Monthly Budget (and Stick to it)
Write down all your mandatory expenses each month then subtract it from your income to find out what's left over. Subtract an additional portion for unknown or unplanned expenses such as vehicle maintenance or birthdays and holidays.
Don't forget to include a portion for personal and "fun" expenses if there is enough. Just like a diet should allow for a cookie now and again, a budget should include some spending on yourself. It helps gives you something to look forward to and helps avoid those impulse buys.
Now that you have your budget, stick to it. If you want to purchase something, do not borrow against next month's surplus. Instead, save your money this money, and then save it next month before buying the item. I've actually seen people spend their entire year's discretionary money in the first couple months.
Use All Extra Money to Pay Off One Debt
Pay the minimums on all your debts, then use all your available money to pay off one. The hard part is choosing which debt to pay. Start by making a list of all the debts, how much you pay each month, the total balance, and the interest rate for each one. Then look at the 3 ways to choose which debt to pay.
Pay the Highest Interest Rate Debt First
If you have a credit card at 18% interest and a car payment at 4%, it might make sense to pay off the credit card first. In this example, the majority of your monthly payment for the credit card will go straight to interest and you will barely pay the principal down. The car on the other hand will have monthly payments that significantly reduce the principal balance and only a small amount each month goes toward interest.
Pay the Lowest Balance Debt First
If you can quickly pay off one loan, you will immediately free up some extra money, which you can then use to pay your next debt. Also, you will be able to see quick results and feel good that your efforts are beginning to work. Just seeing your number of monthly bills to pay drop from 10 to 9 can have a huge psychological affect.
Pay the Debt With The Lowest Balance to Payment Ratio
Take the total debt and divide by the total monthly payment to get the ratio. If you have a credit card with a balance of 2500 and a monthly payment of 45, your ratio is 55.6. A car with a remaining balance of 5500 and a monthly payment of 374 will give a ratio of 14.7.
Essentially, this ratio tells us how many dollars you need to pay in order to reduce your monthly payment by $1. For every 14.7 dollars you spend toward the car, your monthly payments drop by $1 where as you have to pay $55.6 to drop your credit card payment by $1.
In other words, paying off which debt gives you the best bang for your buck. The car is almost paid off already, so just getting to the finish line will free up a lot of money every month you can use to kill debt.
Snowball the Debt Payments
Now that you have paid off one debt, use all the savings to pay off the next debt. You've already set a budget for paying off debt, so instead of spending the savings, just use it toward more debt payments.
If you are spending an extra $100 per month to kill debt, and you pay off that first credit card which had a monthly payment of $35, now use that $100 + $35 to pay the next debt. As you roll down the hill of debt, you will pay more and more toward the next debt, paying each one off faster.
Use as Much of Your Savings as Possible
If your savings is earning less interest than your loans, you should use the savings to pay the debts. You may be earning 1% in a CD but your credit card is charging you 12%. Take that money from the CD and pay off the debt. You will save far more than you are earning in interest.
Don't forget to leave some cash just in case an emergency pops up. We don't want to have to rely credit cards to pay these unexpected expenses when we just got them paid off.
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Be Extremely Cautious About Using Long Term Debt to Pay Short Term Debt
Banks will encourage you to use a home equity loan to pay off your credit cards, cars, or other debts. This might make sense in some circumstances, but the problem is people pay off those debts but don't make the lifestyle changes to avoid accumulating more debts. Now, they have a home loan and all the same credit card debts again to pay and the hole gets deeper.
I am going against a lot of financial expert's advice with this one, but let's think about this logically for a second. You have a 5-year car loan that you pay off and wrap into a 30-year home loan. A car might have a useful life of 7 years or so, but you are now paying for that car for 23 more years after you've stopped driving it. It just doesn't make sense most of the time.
If you have made very serious lifestyle changes and a taking a home loan is the only way to allow you to pay off the credit cards, then it might make sense. It also might make sense if you are paying extremely high interest rates and you get a really good rate on the home loan. The important part though is that you must be dedicate to paying off the loan as quickly as possible to take advantage of the savings.
Dedicate Yourself to a Debt Free Lifestyle
Once you have cleared all your debt, you need to maintain it. It's far too common for people to pay off debts then immediately get back into debt with all that spare money they have every month.
Instead, focus on investing that money to earn even more in the future.