How to Get Out of Debt
Whether you have a couple of delinquent credit card accounts or hundreds of thousands of dollars in delinquent student loans, the most powerful and effective method I’ve seen in my career is the following three-step method made popular by Dave Ramsey. But warning: while these steps may be easy to understand, you WILL fail if you don’t take them seriously or do this half-assed. Each one of the 3 steps MUST be followed and in their correct order. This is a no bs’n allowed strategy, period.
Effective debt elimination involves three steps:
1. Stop acquiring new debt.
2. Establish a small emergency fund.
3. Implement a debt snowball.
1. Stop acquiring new debt
Now even though this step may seem completely obvious to many of you, between 60-70% of the people I work with on debt reduction plans attempt to skip this step then wonder why their debt free journey feels like they’re running in a hamster wheel. Once I catch them in the act and correct the problem, a couple of months later their eyes open up and they become amazed at how much progress they’ve begun to achieve.
What does this mean for you? It means you must, must, MUST get off the “credit crack” before any progress is to be made. This means no new car loans, no payday loans, no money borrowed from friends or relatives and also, most importantly, it means DESTROYING your credit cards. Yes, all of them…even “vicky secret”. Trust me, once you look at the secret in the fine print, she’s really not the friend you think she is.
So yes, if you try to skip this step then you will fail. Besides, no one ever got drug free by sleeping at a crack house every night. Think about it.
2.Establish an emergency fund
“Why save any money before getting rid of your debts? Doesn’t that seem backwards?” Well what we’ve learned about personal finance over the years is that it’s both “personal” and “unpredictable” to say the least. As a matter of fact, it should be call Unpredictable Personal Finance so people are forced to focus on the most important goal – to stop thinking your situation tomorrow is promised so you can begin planning for it today. We learned this hard lesson through the great recession over the last couple years.
Each person’s financial situation of course tends to be affected by a variety of unforeseen elements and especially while attempting to pay down debt, the more you prepare for these “emergencies” if you will, the more likely you are not to be knocked off course from your goal.
While on course to pay off debts it is highly possible you get laid off or find your resources pulled elsewhere. What generally happens is: 1. You’re paying down debts, an emergency happens and your emergency fund covers whatever you’re going through OR 2. You’re paying down debts, an emergency happens then your only choice is to get yourself caught up in payday loan trap with 400% APR. I’ve seen this way too many times. Please don’t end up in situation #2.
So how much for an emergency fund? Most financial advisors will tell you to build up an amount totalling 6 months worth of your current fixed monthly expenses (not your Burke Williams spa treatments but rather, food, rent,telephone, loan payments etc.). In my opinion, I side with Dave Ramsey where I think its best you save $1000 for a small emergency fund, completely pay down your debts then return to this category. When you do return to this category and build up that 6 month emergency fund, that 9 month emergency fund or whatever you choose, this category will help you stay out of debt.. Just remember- EMERGENCY FUNDS are for EMERGENCIES ONLY – not because you found a last minute deal on a round trip ticket to Jamaica.
3. Implement a Debt Snowball Plan
A debt snowball plan (in layman’s terms) is when a list of debts are paid off according to their size (smallest to large) vs how they are traditionally paid off – by interest rate. The debt with the lowest balance (the target debt) has the most money paid on it each month while you pay the minimum amounts on all remaining debts. Once that target debt is paid off, you use the previous amount you were using on it and apply it to the next debt on your list according to size. Eventually the debt snowball starts to pick up steam as the smaller debts are knocked out and you find yourself with increased monthly amounts to be used to tackle the larger more stubborn debts.
This method works particularly well because a lot of people don’t realize that debt elimination is 80% mental and 20% actually how much you pay. Most people who have previously tried to tackle a list of debts and have decided to quit will tell you that a major reason for quitting was that it felt like they weren’t making any traction in the process. A debt snowball plan eliminates this problem.
More info on what a debt snowball plan is:
A great debt snowball calculator for you to use:
Stay tuned for my next post “How to STAY out of debt” . And FYI- setting up a budget wasn’t included in these three steps because that is the prerequisite for any advice you take on this site. I don’t care if you just use Mint.com. Whether investing, paying down debts or even starting your own business – the budget is the bible. Read more about that here.