"It gives much more pain to the mind to be in debt, than to do without any article which we may seem to want.”
Let’s be honest: There’s no quick and easy way to get out of debt; it takes time and effort. That said, it can be done—and has been done by millions of people just like you.
Before you can begin to destroy debt, you have to understand the basics of cash flow, since cash flow problems were what got you into debt in the first place. After you’ve got that concept under your belt, you can begin to focus on reducing debt. Although there’s just one basic debt-elimination process, you can apply it in a couple of ways. The key is to find the method that works best for you. This chapter explains your options.
“The first step to happiness is spending less than you earn,” write Arun Abey and Andrew Ford in How Much is Enough? (Greenleaf, 2009). You’ve probably heard that before, and if you’re in debt, you might think it’s lame advice. But the truth is, spending less than you earn is the key to all personal finance.
When you spend more than you earn, there’s never enough money to go around. You’re always $50 or $100 short of what you need, and you fall further behind every month. You end up spending money you don’t have—using credit cards, taking out loans—which leads to more debt, which puts you deeper in the hole.
You can’t possibly get ahead when you spend like that. The math simply doesn’t work. In order to save money and pay off debt, you need to spend less than you earn. Although it’s easy to understand this intellectually, it’s only when you actually see the concept applied to your own life that you’ll be able to appreciate the power of positive cash flow.
Simple, right? That’s second-grade math. But don’t let the simplicity fool you—this is a powerful concept. This formula tells us two things:
The greater the gap between earning and spending, the faster you build (or lose) wealth. This may seem obvious, but smart personal finance really is this simple. Everything else—clipping coupons, saving for retirement, asking for a raise—is done in support of this basic idea.
Here’s an example: Joe Spendsalot has been living paycheck to paycheck, making minimum payments on his $5,000 credit card debt. Joe brings in $2,500 per month after taxes, but he spends $2,600 a month, including $100 per month on his credit card bill, which barely covers the 15% interest. Because he spends more than he earns, his cash flow is negative, and he’s sinking into debt.
|Cash Flow: $2500.00 – $2600.00 = –$100.00|
Eventually Joe realizes he can’t continue to spend more than he earns; he’s just digging himself a deeper hole. He decides to make some small changes to cut his costs, including biking to work and using the public library for free entertainment. Together, these save him $100 per month. Now his monthly income and expenses are both $2,500, so his cash flow is zero: He’s not saving anything, but he’s not taking on any more debt, either.
Joe continues to pay $100 per month to his credit card bill, but the balance never seems to drop. Running the numbers, he realizes that at this rate it’ll take him decades to pay off his credit card. In fact, according to the Federal Reserve’s credit card repayment calculator (http://tinyurl.com/CCcalculator), he’ll be paying on that debt for 24 years.
Joe decides to increase his cash flow by taking a part-time job at the local mini mart, where he earns an extra $250 per month. He also cancels his cellphone plan, begins cooking more meals at home, and switches to store-brand groceries, all of which saves him $250 per month.
|Cash Flow: $2750.00 – $2250.00 = +$500.00|
Now Joe’s bringing in $2,750 per month after taxes and spending $2,250 per month, giving him a positive cash flow of $500. If he’s disciplined and uses all this surplus to pay down his credit card, he can be debt-free in just 9 months. And once he eliminates his credit card debt, he’ll no longer have that $100 monthly payment, so his monthly cash flow will increase to $600. He can quit his job at the mini mart and still set aside $350 a month for saving and investing—and fun.
You might be saying “There’s no way I can find an extra 600 bucks every month!” That’s okay. Say you can manage to cut your spending so that you have a positive cash flow of $100 per month. Psychologically, the difference between losing $100 each month and gaining $100 is huge: It’s the difference between feeling like you’re being buried alive and feeling like you’re climbing out of the pit. Even if your $100 positive cash flow is all going toward debt, you’re still making progress.
People make these sorts of changes every day. In fact, this is exactly how I, your humble author, got out of debt (see the box on The Basics of Debt Reduction), and how many of the readers at Get Rich Slowly (www.getrichslowly.org) have done the same.
The bottom line is that in order to conquer debt you need to have a positive cash flow. We’ll explore ways to cut your spending in Chapter 5, and we’ll boost your income in Chapter 6. For now, let’s look at how to use a positive cash flow to pay off debt.
Many people look for magic bullets to get them out of debt: They play the lottery hoping for a big payout, or they listen to the snake-oil salesmen on TV who promise instant solutions. The truth is, there aren’t any instant solutions. There are, however, some time-tested, proven techniques.
Being in debt because of student loans or a medical emergency is different from being in debt because you spend too much. If spending isn’t your problem, you can skip to the section on establishing an emergency fund (Establish an Emergency Fund). For advice on paying off student loans, check out http://tinyurl.com/st-loans; and you can find an article about medical debt from Smart Money at http://tinyurl.com/doc-debt.
If your debt is out of control, it’s because you have a negative cash flow—you’re spending more than you earn. The first step on the path to debt-free living is to reverse this cash flow. For most people, that means it’s time to stop using credit; credit makes it way too easy to spend more than you have.
Nobody needs credit cards. Don’t try to make excuses for why you have to keep them: You don’t need them as a safety net, for convenience, or for cash-back bonuses—you can get by without them. (Turn to Your Credit Report to read about someone who lives without credit cards.) If you’ve had problems with credit cards, the worst thing you can do is hold on to them. It’s like an alcoholic keeping a couple beers in the fridge in case he gets thirsty. When your debts are gone and your finances are under control, then you can get a credit card; in the meantime, make do with a debit card.
It can be tough to quit credit cold turkey; I know from first-hand experience that it’s easy to find reasons to whip out the plastic. If you’re really struggling with credit-card debt, your best move is to remove the temptation completely: Destroy your credit cards. Don’t put them in a desk drawer, and don’t freeze them in a block of ice; you’re better off shredding them, burning them, or cutting them into tiny pieces with scissors.
After you destroy your cards, halt any recurring charges. If you have a gym membership, cancel it. If you automatically renew your World of Warcraft account every month, cancel it. Cancel anything that automatically charges your credit card. The point is to completely stop using credit.
Once you’ve done this, you’ll need to decide whether you’re going to close your credit card accounts or leave them open. If you try to cancel a card that has a balance on it, the issuer may want to jack up your rates or do other evil things. Plus, it’ll ding your credit score (see How and When to Cancel a Card). But so what? If you have trouble with credit card debt, you’ve got to remove the temptation; if you don’t close your account, you can still use it to shop online even if you’ve destroyed the card. Besides, when you call to close your account, some card issuers will let you lock in a lower rate by putting you on a payment plan.
“Hi. I was just browsing online at CardRatings.com and I see they have a card from [Other Bank] that has an APR of just 10%. I’m paying 18% APR on the card I have with you. I’d rather not switch, but 8% is a lot. Is there anything you can do to help me out?”
Your bank may not agree to match the terms, but then again it might. You’ll have better luck if you’ve been a long-time customer, paid on time, and used the card regularly. Be friendly but insistent, and don’t make any threats you’re not prepared to follow through on.
The next step is to sock away some savings. Use that positive cash flow you’re building to set aside a little self insurance, money you keep on hand in case of emergencies. This helps you cut costs because it’s cheaper than paying an insurance company to handle unexpected catastrophes. (See General Insurance Tips for more about self insurance.)
It may seem counter-intuitive to try to save up a little bit of money while you’re still in debt, but if you don’t save before you begin paying down debt, you’ll struggle to cope with unexpected expenses.
Whatever you do, don’t use a credit card to pay for emergencies; a credit card is not an emergency fund. Instead, destroy your credit cards and save for emergencies.
How much should you save? Ideally, $1,000 is a good amount to start with. (If your expenses are low, you might be able to get by with $500.) Keep this money liquid, but not immediately accessible. In other words, make it easy to get to—but not too easy. Don’t keep your emergency fund in your main checking account, for example; consider opening a separate account at a new bank. (Chapter 7 has tons of info about bank accounts.)
Don’t tie your emergency fund to a debit card; that just makes it easier to sabotage your efforts by using the debit card to pay for non-essentials. This money is for emergencies only, not for beer, clothes, or a new iPhone. It’s for when your furnace croaks or you break your arm or you lose your job.
A good option is to open a high-interest savings account at an online bank like ING Direct or HSBC Direct. (For a list of online banks, check out http://tinyurl.com/savingACT or flip to Online banks.) That way, when an emergency arises, you can transfer the money to your regular checking account. It’ll be there when you need it, but you won’t be tempted to spend it rashly.
After you’ve stopped using credit and created an emergency fund, then go after your existing debt. Attack it with vigor—throw whatever you can at it. The best way to do this is to use a technique called the debt snowball, which lets you build and maintain debt-destroying momentum. Here’s the basic method:
Make a list of your debts in the order you want to destroy them. (You’ll learn a couple of good ways to prioritize debts in a moment.)
Set aside a certain amount of money to pay toward debts each month ($500, say).
Throw every other penny at the first debt on the list.
But here’s the key to making the debt snowball work: After you’ve destroyed your first debt, you’ll find you’ve freed up a bit of cash; because one of your debts is gone, you have one less monthly payment. You could take this money and use it for something else, but you’re going to do something smarter: keep paying the same total amount—$500, in our example—toward debt every month.
Clear as mud? Let’s look at a couple of examples that prioritize debt reduction in different ways.
Conventional wisdom says that you should pay off debt from the highest interest rate to the lowest interest rate. Let’s say our friend Joe Spendsalot (Cash Flow Basics) is dating a woman named Karen Kashout. Karen is a typical twenty-something who wakes one morning to realize that she’s in debt, and she decides to do something about it. She’s burdened with the following liabilities:
$20,000 student loan at 5% interest
$8,000 credit card balance at 12%
$2,000 computer loan at 10%
$3,000 car loan at 4%
Technically, the quickest way for Karen to conquer her debt is to pay off the balances with the higher interest rates first, so she’d tackle them in this order:
$8,000 credit card balance at 12%
$2,000 computer loan at 10%
$20,000 college loan at 5%
$3,000 car loan at 4%
Using the debt snowball method described above, Karen would pay the minimums on the bottom three debts and throw all the money she could at her credit card balance. Once she destroys that debt, she’d pay the minimums on the bottom two debts and throw all of her money at the computer loan, and so on.
Mathematically, the high-interest payoff plan does indeed make the most sense. That’s because paying interest works against you in the same way that earning interest works for you (see The Power of Compounding), so paying off your highest interest debt first is technically the best use of your money—if you follow this plan, you’ll pay less in the long run. But this plan works only if you have the discipline to stick to it, and even if you know it’s the right thing to do, that’s no guarantee it’ll work for you.
I struggled with debt for a decade (see the box on The Basics of Debt Reduction). I made several attempts to pay off my debt using this highest-to-lowest interest method, and each time I failed. My highest interest rate debt was also my debt with the highest balance, so I felt like I was paying and paying but the balance never dropped. I’d get discouraged and give up on ever paying off my debt.
That’s not to say you shouldn’t try this method: If it works for you, use it! But if you struggle, consider the next method, which is the one that helped me succeed.
It might help you to have a visual representation of your debt-paying progress. Try this: Take a piece of graph paper and block off squares to represent your debt. (You might use one square for every $100, say.) When you make a payment, mark off a square—and give yourself a pat on the back. (If you’re a geek, build yourself an Excel spreadsheet that does something similar.) These little progress reports are cheesy, but they can keep you on track.
If you’ve tried following the highest-interest-rate-first advice and still struggle with debt, there’s another way. In his book, The Total Money Makeover, Dave Ramsey advocates an approach to the debt snowball that tackles accounts with low balances first. (Ramsey didn’t invent this method, but he’s popularized it over the past decade.)
With this version of the debt snowball, you ignore interest rates when determining the order in which you’ll pay off your debts. All you look at is how much you owe, organizing the debts from smallest balance to largest balance.
Our friend Karen Kashout, for example, would arrange her debts like this:
$2,000 computer loan at 10%
$3,000 car loan at 4%
$8,000 credit card balance at 12%
$20,000 college loan at 5%
After she lists her debts from smallest to largest, she’d make the minimum payment on all of them except the smallest: the computer loan. She’d throw every dollar she can at the computer loan until it’s gone, and then move on to her next smallest debt, the car loan.
This method may not be as quick as paying your high-interest debt first, but it provides tremendous psychological reinforcement. You get some quick wins—checking creditors off your list—that encourage you to keep at it. Dave Ramsey calls this “behavior modification over math,” and he’s right: The most important thing when paying off your debts is to, well, pay off your debts; the order in which you do so is irrelevant.
Critics of this approach argue that the math doesn’t make sense, and they’re right: If you use this method, you will pay more interest than if you had the discipline to pay off your debts based on interest rate. But humans are complex psychological creatures, not adding machines. We usually know what we ought to do, but that doesn’t mean we always do it. If we were adding machines and always made the best choices, we wouldn’t get into debt in the first place!
You can use the debt snowball to get out of debt in other ways. For instance, you might decide to first target the debts that give you the biggest headaches. Do you have a loan from your sister and her husband? Do you hate the fact that you borrowed money to buy a new computer? Whichever debt bugs you most, pay it off first.
To learn more about the debt snowball and the various ways to use it, download this free spreadsheet from Vertex 42: http://tinyurl.com/v42-debt. (You can see a video demo of the spreadsheet at http://tinyurl.com/v42-video.)
Regardless of which order you use to destroy your debt, put as much money as possible toward this goal. Apply raises and windfalls (like tax refunds) directly to your bills. Sure, you’d rather spend that birthday check from grandma on a night out with your friends, but it’ll do you more good if you use it to pay off that last night on the town. You’ll have plenty of time to spend future windfalls; for now, use the money to get debt off your back.
And if someone tells you that you you’re being stupid if you don’t follow a debt-repayment plan that minimizes interest payments, just ignore him. The ultimate goal is to get your debts paid off. Know yourself and choose whichever method makes the most sense for you and your financial situation.
For the lowdown on the pros and cons of using home-equity loans to pay off credit card debt, head to this book’s Missing CD page at www.missingmanuals.com.
You can do lots of other things to improve your situation while you’re working on the three main steps of debt elimination. But all the debt-reduction tips you’ll find are based on one simple fact: To pay off debt, save money, or accumulate wealth, you have to spend less than you earn—in other words, financial success comes from having a positive cash flow.
It’s not always easy to find ways to earn more money, but almost everyone can find ways to curb their spending. Developing frugal habits is a great first step toward being debt-free. Some people think that frugal living is equivalent to being “cheap,” but that’s not the case. Frugality and thrift used to be core values in our society, but we lost touch with these ideals during the age of easy credit. Thrift can be a fun way to stretch your hard-earned dollars. (The next chapter discusses ways to be frugal.)
While you learn to spend less, do what you can to increase your income. Try selling some of the Stuff you bought when you got into debt. This can be painful, but ask yourself: Do you really use that weight bench? Is your DVD collection really doing you any good? Use eBay.com and Craigslist.org or the Amazon Marketplace to get some cash for the things you own. Consider taking an extra job or working longer hours. (For more on boosting your income, see Chapter 6.)
Finally, go to your public library and borrow a book on debt reduction. After you finish it, borrow another book about money. The more you learn about smart money management, the easier it’ll be to make the right choices.
The most important thing is to start now. Not tomorrow, not next week—start tackling your debt now. Have patience and don’t get discouraged if your efforts seem small and insignificant at first. Trust me: Most of us started paying off our debts the same way. In time, your efforts will bear fruit. If you’re willing to persevere, you’ll have your debt paid off sooner than you think.
Many people get into debt because of compulsive spending. They can’t keep from buying more—even when that means spending money they don’t have. “Overspenders…have confused and confusing relationships with money,” write psychologists Brad and Ted Klontz in Mind Over Money (Broadway, 2009). “On one hand, they’re convinced that money and the things it can buy will make them happy; yet they’re often broke because they can’t control their spending.”
A spending addiction is a scary, dangerous thing. Like other addictions, it makes victims feel out of control. (The Illinois Institute for Addiction Recovery has a list of money habits that indicate a problem with compulsive shopping or spending: http://tinyurl.com/shoppingsigns.)
In Mind Over Money, the authors note, “Overspending can become a vicious cycle. Overspenders experience an irresistible impulse to spend; they lose control over their spending, and then, to ease the anxiety over having lost control, they continue to buy.”
People who’ve never suffered from compulsive spending can’t understand the problem, and you may have a hard time explaining it to them. They don’t know what it’s like to see something and feel the urge to buy it now. They don’t know the lure of the shopping “rush”—and the subsequent nausea from the guilt of having spent money they don’t have.
Cut up your credit cards. Don’t make excuses to keep them—if you have a problem with compulsive spending, destroy your credit cards now. Don’t jot the numbers down someplace “just in case”; that makes it too easy to go to your desk drawer, pull out the numbers, and place an order online. Get rid of your credit cards completely.
Carry only cash. Don’t use your checkbook or a debit card. Inconvenient? Absolutely, but that’s the point. If you’re a compulsive spender, your goal is to break the habit. To do this, you’ve got to make sacrifices. Spending cash will help remind you that when you buy something you’re actually spending money. Plastic (and to some degree checks) make this connection fuzzy.
Track every penny you spend. You may not even be aware of how much you’re spending. Lunch every day at McDonald’s—how much could that possibly cost? Picking up a few magazines on the way home from work—what harm is there in that? Once you begin to track your spending, patterns become clear. When you see these patterns, you can act on them. (For more on how to track your spending, see Tracking Your Spending.)
Play mind games. For some people, money isn’t an emotional issue. They’re able to make logical choices and not be tempted to do otherwise. For most of us, though, it doesn’t work that way. If you’re in this majority, it can be useful to play tricks on yourself. You might train yourself to use the 30-day rule (see Where to Find Help), for instance. I’ve found that I can often keep myself from spending by simply adding the Stuff I want to my wish list at Amazon.com; I come back weeks later and can’t remember why I wanted it in the first place. Here are some questions to ask yourself when you’re tempted to buy: http://tinyurl.com/GRS-tempted.
Avoid temptation. The best way to keep from spending money is to avoid situations that tempt you to spend. If your weakness is music, stay out of record stores and de-activate your iTunes account. If you tend to overspend at big department stores, stay away from the mall. Avoid the places where you normally spend.
Ask for help. It’s tough to beat an addiction alone. Seek support from your friends, family, and spouse—and don’t get angry when they call you on your missteps.
Consider professional help. There’s no shame in seeking therapy for help with problems that seem bigger than you. You have to look inward to overcome any form of addiction; a therapist is like a trained guide who can help you to find the way.
The good news is that you can break free from emotional spending. The bad news is that it’s going to take work and it won’t happen overnight. You’ll make mistakes and backslide, but when you do, don’t give up and don’t beat yourself up over it. You’re human, after all. Stay focused on your long-term goals, and resolve to do better next time.
The sad truth is that not everyone can dig out of debt alone. For some, life just deals too many blows, or they can’t seem to control their spending, or they don’t earn enough money to make headway on their payments.
If you feel like you’ve tried everything but you still need help, don’t turn to the debt-settlement companies that advertise on TV and radio. They don’t have your best interests at heart—they’re in it to make money. (For more on the problems with debt-settlement companies, check out this article at MSN Money: http://tinyurl.com/msn-debtsettlement.)
If you need help with debt, turn to reputable sources. First, go to your public library and borrow two books: How to Get Out of Debt, Stay Out of Debt & Live Prosperously by Jerrold Mundis (Bantam, 2003) and The Total Money Makeover by Dave Ramsey.
In his book, Mundis recommends one simple action to start you on the path to debt-free living: “Just for today, one day, do not incur any new debt. Not one.” Make—and keep—this promise to yourself, just for today. (And then make and keep the same promise tomorrow.)
This chapter has already covered many of the key lessons from these books, but they go into a lot greater detail than we can here. If you’re struggling, take the time to read these books and apply their lessons. If you still need help, the next few sections discuss a few different places you can turn.
Debtors Anonymous (DA) is a twelve-step program for people struggling with debt and compulsive spending. DA started in 1968 when a group of Alcoholics Anonymous members noticed that, for them, debting (spending money they didn’t have) was an addiction just like alcoholism.
Debtors Anonymous believes that many people get into trouble with debt because they don’t really pay attention to their spending. They spend without thinking about the consequences. To fight this habit, DA encourages members to track their spending (as described on Tracking Your Spending) and develop some sort of budget. (Many DA members use the envelope method explained on Envelope Budgeting.) The Jerrold Mundis book recommended above is based on DA’s principles.
To learn more about DA, go to www.debtorsanonymous.org or call 1-800-421-2383.
Being hounded by debt collectors? Know your rights! The Federal Trade Commission has a handy guide to the Fair Debt Collection Practices Act at http://tinyurl.com/FTCcollections. Don’t let creditors push you around.
The National Foundation for Credit Counseling (NFCC) is a network of nonprofit credit counseling agencies that help people take control of their finances and get out of debt. When you contact an NFCC agency, they’ll work with you to create a debt management plan (DMP).
With a DMP, you pay off your debts by making monthly payments to the credit agency you’re working with; they then send these funds to your creditors. Some creditors may be willing to reduce interest rates or waive fees if you’re using a DMP. In a lot of cases, if you show a good faith effort to work with them, they’ll work with you.
A debt management plan can ding your credit score (see Your Credit Score), but it’s not a permanent penalty. Since you shouldn’t be taking out new lines of credit if you’re in this situation anyway, that’s a small price to pay to break free from the chains of debt, don’t you think?
One added benefit of working with a credit-counseling agency is that they’ll act as the go-between for you and your creditors. If you’re being hounded by debt collectors, the agency will take the calls for you—how cool is that?
Credit counseling isn’t always free, but some agencies do offer their services for low (or no) fees. For more information, contact the National Foundation for Credit Counseling at 1-800-338-2227 or www.nfcc.org, and check out the box below for tips on selecting a counselor.
There’s been a lot of Dave Ramsey in this chapter, and there’s a reason for that: Ramsey is the guru of debt reduction. His advice has helped hundreds of thousands of people—including me—to stop spending and start living debt free.
Ramsey’s company, The Lampo Group, offers a 13-week course called Financial Peace University (FPU) that provides hands-on training in debt reduction and money management. FPU takes 2 hours per week and costs about a hundred bucks for the entire course. The classes teach you how to save, budget, invest, and—of course—pay off debt.
One thing to know about Financial Peace University: Ramsey is a devoted Christian, so his program incorporates Biblical principles and the classes are usually held at churches. For many people, this isn’t an issue, but it might bug you. If you’re a non-Christian considering FPU, you may have to just deal with the religious language. Or you can use the class finder at http://tinyurl.com/FPUfinder to see if any credit unions or nonprofits in your area are offering the course. There’s also an online version of the class available: http://tinyurl.com/FPUonline.
It’s not getting out of debt that’s important—it’s the freedom that being debt-free can bring you. When you’re chained to the shackles of credit card payments and student loans, your choices are limited. You feel trapped in your crummy job because you can’t afford to quit.
Debt can feel so overwhelming that you think you’ll never escape, but the good news is you can. It’ll take hard work, but you can do it. Although debt repayment can seem daunting at first, it won’t take forever.
The most important thing is to start now. Waiting to get out of debt is a fool’s game—it doesn’t help anything. Begin with baby steps if you need to, but do something. For starters, turn the page to Chapter 5, where you’ll learn ways to cut your spending.
The toughest part of taking control of your finances is getting started. I recommend setting aside a single day (a “Money Day”) to tackle all of your financial chores at once. To learn more, head to this book’s Missing CD page at www.missingmanuals.com.