The steps of becoming debt-free are simple by principle. But when you actually face the fact that there is debt in your name, everything becomes a bit more difficult in getting rid of that debt.
In becoming debt-free, we need to figure out which debt it good debt and which is bad debt. For example, if you need to borrow $200,000 to buy a home, this is good debt. With that money, you’re buying an asset that will appreciate each year you have it. In addition, your loan will (likely) be put on a term. This means that if and when you make your payments, you know how much is going towards interest. And of course, the interest rates are generally pretty low. Another benefit is that the interest that you pay on this debt is tax deductible.
Now let’s look at credit card debt. This is a bad debt. The interest that you pay is usually pretty high, its not tax deductible, and it’s compounding interest. This means that interest will accrue, and then next month when they calculate interest again, they will calculate the new balance including the interest that accrued the previous month. And you probably didn’t use that money to buy anything that you needed or anything that will appreciate in value.
So, for those of you paying attention, you will probably know my step 1.
1. Get rid of credit cards and their debt. Let’s say you have a fairly cheap credit card that only charges you 10%. What does your savings account give you? 4% at best? Put your extra money into paying down your credit cards, and you will end up saving more money on interest from the credit cards than you would from your savings account. When you no longer have a credit card to pay off, then you can put more money into savings.
2. Keep credit cards open, but don’t use them. If you close all of your credit cards, your credit score will go down. You want to have that availability there, but just don’t use it. When your credit score goes up, the interest rates you have to pay go down. It’s that simple.
3. Keep your good debt. Becoming debt-free doesn’t mean you have to pay off your mortgage. Sure, it would be very nice to not have to make a payment for your home every month, but it’s good debt for all the reasons I’ve outlined above.
4. Eliminate every debt you have whose interest rate is higher than your savings account interest rate. This is very similar to step 1 with the credit cards, but I’d also like to include debts such as auto loans, hospital bills, or anything else that might be out there.
5. Eliminate one debt at a time. Let’s say that you have a car loan at 10% interest rate, a credit card at 16% interest, and another credit card at 23%. Let’s say you pay $400 ($275-car loan, $75-23%credit card, $50-16%credit card) towards these bills each month paying the minimum and put $150 into savings each month. Put that extra $150 towards the 23% credit card until it’s gone. You’ve now been paying $550 towards these three bills each month. So when the 23% credit card is paid off, continue to to pay the $550 each month. Instead, pay the $275 auto loan, then put the entire $275 into the credit card. When that’s paid off, do the same for the auto loan. Doing this method will save you A LOT of money, but won’t add to your savings much.
However, if you are committed to eliminating debt, this is the best option for you! Be willing to live on a tight budget for a few months and see what a difference it makes!