Thomas Edison said, “There is no substitute for hard work.” It’s so simple, but so true; and so fitting for the topic of debt reduction. There is no magic solution or easy way out. But while there’s no denying it’s a painful process, anyone can do it with commitment, discipline, and patience. And if you’re going to put in that much effort, you had better make sure you do it right…which means making sure it never happens again!
First, a Warning:
You’ve no doubt seen the advertisements and websites out there for “Debt Consolidation” and “Debt Management” companies. Both types of companies should be considered last resorts. Here’s why:
- Debt Consolidation – These companies take your credit cards and loans and consolidate them into one loan; often with a payment lower than your previous combined total. The problem, however, is that in order to lower the payment, the term of your loan had to be extended; so you’re only prolonging your indebtedness. Further, these companies are in business for a reason…they’re making money off of you! Their profit is built into the new consolidated loan and you wind up paying more in total payments than what you originally owed.
- Debt Management Advice – These are the credit counseling services you hear about. Basically, you pay them a monthly lump sum and they take over the job of paying your bills for you. Often, they negotiate more favorable terms on your behalf as well. So what’s the catch? While your score itself is not affected, your credit report will now show your accounts as being managed by a debt counseling service. Speaking as a former underwriter, this does not go unnoticed!
In addition to the problems mentioned above, the real flaw in these systems is that they don’t tackle the underlying problem; what likely got you in this mess to begin with: bad financial habits!
Here are some basic steps to take toward eliminating the debt yourself and developing good (permanent) financial habits in the process:
- Create a budget. Use one of the many free tools available, or create your own on a spreadsheet. The point is to assign every dollar of your paycheck to a category.
- Review your budget and make some tough decisions on what can go. Be ruthless, debt elimination is not for the faint of heart!
- Carve out the monthly amount you will devote to debt elimination. Make this one of your fixed expenses to be paid immediately after you receive your paycheck.
- Stop spending. If you have to, shred your debit card and only use cash. Definitely shred all your credit cards except one (preferably the one with the lowest rate) for emergencies.
- Try to lower your payments. Explore the possibility of refinancing your home and/or car and call your credit card companies and ask for a lower rate (always worth a shot!)
- Inventory your “bad” debts. This is pretty much any debt besides your mortgage, which has tax advantages and is secured by an appreciating asset. List everything on a spreadsheet, including the minimum payment for each, then prioritize them.
- It’s generally best to prioritize in order from highest to lowest interest rate.
- An alternative way for prioritizing is the Dave Ramsey “snowball” method, where the order is smaller balances to higher balances. The theory is that the gratification you get from achieving small goals early on makes you more likely to stick with the program long-term.
- Set your payment schedule. Take your amount from step 1b and divvy it up. Cover only the minimum payment on all the non-priority debts; everything else goes to the debt at the top of the list. Tackle one debt at a time using this system.
- Consider additional sources of income. This could include selling assets or other side jobs. Any additional income goes straight to the debt currently in the top priority position.
Do whatever it takes to keep your eye on the prize…imagine the feeling of accomplishment when you’re debt free and you know you did it yourself! Not only did you eliminate your debt, you also acquired lifelong healthy financial habits. And don’t forget the icing on the cake: your shiny new credit score!