Getting out of debt is much like a diet to lose weight. If you want to lose 100 lbs. it will take a defined strategy along with a change in your behavior. Likewise, if you want to lose 5lbs, you may just need to cut out some sugar or exercise an extra day or two. In either case it requires a plan and discipline to succeed. It is no different for eliminating your debt.
There are three key steps in building a strategy to eliminate debt: identify your spending habits, create a budget, and develop a repayment strategy.
Let’s begin with the first step of indentifying you spending habits. This may seem obvious, but the easiest thing to remember here is to not spend more than you have. If you are in debt, no matter how good the sale is on that LCD TV, unless you have the cash to pay for it now you should not buy the item.
If you are trained to buy everything on credit cards, changing your habits to only spend what you have will be the single most important behavior change. It will fill like you can not buy anything, however, there is hope as you will see in the second step when you create a budget.
Once you understand the concept of not spending more then you have, it will be time to create a spending matrix. For two weeks track everything you buy for each day and put them into these categories: living expense, food, entertainment, other. The more detail you put the better you will be able to identify places to save money. How you create your matrix is up to you. It can be a simple sheet of paper you write everything on, an excel spreadsheet, or you can use software such as Microsoft Money or Quicken.
Once you have your spending matrix created simply list out your mandatory expenses (car payments, rent, credit card bills, etc.). You should now have a good sample of your monthly expenses in you project out the average of the two week spending matrix.
Now that you know your spending habits, you can move to the next step of creating a budget. For many this is a four letter word, but if done right, it can help you control spending, save money, and payoff debt.
To really get the best results from creating a budget the previous step comes into play. Many budgets fail because people do not understand their spending habits and create an unrealistic budget that does not take into account all the small expenses that ad up. If you took the time to monitor your spending for at least two weeks, you should be able to identify what you need on a monthly basis and create obtainable goals. Furthermore, you can really dive down into the details and determine where you can switch things to decrease your monthly expenditures. For example, buying generic vs. name brands might save you $20 per month, reduce name brand coffee from 5 days to two days might save you $40 per month, etc.
When you create your budget, make sure to give yourself some entertainment and flexibility. How much you give yourself depends on your situation, but at the end of the day if you remove all elements of items that bring you enjoyment you are more likely to fail.
The next important piece is to not only find ways to increase how much you pay to your total debt, but also to find a portion to dedicate to savings. No matter how small it is, you should have an amount that goes into a place that is hard to touch (a savings that takes a day or two to transfer funds, a brokerage account, etc.). Over time this will build and as your income increases or your debt shrinks you can increase the amount of savings.
It is now time to develop your repayment strategy. Often this is where many people spend the least amount of effort. They simply pay the bills plus any extra they have to send. While this works, it is not the quickest way to reduce your debt.
The first thing you have to understand is what type of debit you have. Most people will have a combination of credit cards, car payments, and/or home loans. The worst kind of credit is typically credit cards or short term cash advanced loans. They come with high interest, high penalties, and non-flexible terms. You goal should be to reduce these types as quick as possible. Remember a phone call to your credit card companies can go a long way to reducing fees. Be persistent, but polite, and don’t easily take no for an answer.
While you are paying the short term debt down, you can also be working on paying down the long term debt without sending any extra cash. How? Simple, most loans calculate interest on a daily basis. If you can pay sooner than the due date you can reduce the interest applied for that month resulting in a greater principle payment. The best way to take advantage of this if you have the cash flow is to set up weekly payments that total the monthly fee you have to pay. On a home loan, over time this can substantially reduce the interest you pay.
Once you short term debt is paid, you then have to determine how to proceed with your long term debt. In some cases, it is better to apply the extra monthly amount you gained in income by paying off your short term debt to an investment account. This comes with some risk, so be careful, but if you do your homework and find safe investments you should be able to make more return on your investments then you pay in interest on your long term debit. Remember to include the tax write off you get each year in your calculation when looking at your home payment.
If you want to apply a safer route, simply partition the gained income into extra payments and savings based on your tolerance for risk. For example, if you freed up $400 a month from paying off short term debts, you might be fine with putting $100 a month to investments and $300 a month on top of your home or car payment. If you investments do well over time, perhaps you change that to $200 per month for investments and $200 per month extra for your home or car payment.
The key is to find the right balance based on your experience and results in earning investment gains.
As your savings and investments grow, there will be a point when you can take the money and pay off large debts like cars and homes. Once you do that, you will have freed up large amounts of income and you will be able to pay cash for that LCD TV and be debt free!