Financial stability is a goal many of us have. So, we’re offering a little guide on how to do just that. You can check back on part I for an introduction and a first-thing’s-first base of operations: your budget. This time, we’re getting a little bit more specific and honing in on the proverbial elephant in the room: debt.
Now, there is good debt, and there is bad debt. Contrary to what many would have you believe, not all debt is from the devil. Some of it is helpful. You might have to take out a loan to get a degree that can get you a better job, or to buy a car to replace that old one that’s falling apart, or to invest in a home. This is good debt. This debt has a purpose.
Now, there’s that other kind of debt that is the devil’s cocktail, and that’s credit card debt. Piles and piles of shoes and clothes and nights out and lattes that you haven’t actually paid for yet, you just promised to pay for them…someday.
Good debt or bad debt, eventually, you need to be free from it to be truly financially stable. Here’s how:
Step 1: Acknowledge the Beast
The first step to changing anything is to acknowledge that you do actually need to change. This can be scary, especially if you haven’t been keeping track of how much debt you’ve accumulated over the years.
Tally up all of your debts and calculate your current negative net worth. Leave your mortgage out of it for now. You can deal with it later, but total the rest up. This is an important number, but not quite as important as the number you’ll get in the next step.
Now, divide your total debt by your annual income. This is your debt-to-income ratio.
- Example: You earn $50,000 a year and have $25,000 in debt. Your debt ratio is 0.5.
This will give your an idea of how serious your debt really is. Generally, 0.0-0.2 is okay, 0.2-0.35 is fair, 0.35-1.0 is where you start getting into trouble, 1.0-2.0 is serious, and 2.0 or more is…well, really serious.
But, however much debt you have, now what you need to do is put on some healthy perspective goggles. If your debt is catastrophic, all that means is you’ve got a lot of work ahead of you. However, if you’re in the “good” to “fair” range, don’t kick back and relax. You want a big fat zero. Don’t brush it off. Small hills of debt accumulated with bad habits can quickly become mountains.
Step 2: Stop Feeding the Beast
Before you can start doing anything drastic to eliminate your debt, you have to take a long, hard look at the behaviors that got you there in the first place. Chances are, the reason you accumulated non-student loan or non-mortgage debt is because you’ve been spending more money than you make.
This is a huge problem, and it has to be stopped before you can get rid of debt entirely, or else the monster will just creep back up again.
So, you’ve got to stop feeding the beast. If you took out a $10,000 loan for a car, don’t take out a $50,000 loan for a house. If you’ve got student debt, don’t immediately rush off to spend money on something else. If you’re in debt from losing your job, try to build up an emergency fund so you have a cushion next time.
And, if you’ve got debt because you haven’t learned how to live within your means, then start figuring out what living within your means looks like for you, and get there. That’s when we get to the next step:
Step 3: Kill the Beast
There are two ways to pay off your debt and become financially free, no matter where your debt came from: spend less money, and increase your income.
It sounds easier than it actually is, I know, but at least you don’t have limited options. There are hundreds of ways to reduce your spending, change your habits, and make more money. Here’s just a few to get you started:
Reduce Your Spending.
- Downsize to a smaller home or apartment.
- Reduce the amount of money you spend on your utilities.
- Use coupons and take advantage of sales.
- Buy items in bulk or secondhand.
- Get creative with your grocery bill.
- Cut up your credit cards.
Increase Your Income.
- Sell unwanted items on Craigslist or Ebay.
- Host a yard sale.
- Turn a skill into a side hustle.
- Sell a craft on Etsy.
- Tutor kids and college students.
- Take on a part-time job, and devote that paycheck entirely to paying off your debt.
This is by no means a comprehensive list. Try some things out, see what works for you, and get creative!
Now, what do you do with all that extra money you’re saving and making? How do you go about actually killing the beast that is debt-mountain?
Well, you’ve got two strategies at your disposal.
The Snowball Method
The Snowball Method for getting rid of debt is pretty popular for a reason: it works. It’s just one strategy among many that can make your mountain of debt seem surmountable, one step at a time. Here’s the basic steps:
- List all your debt owed on separate accounts in ascending order from smallest balance to largest.
- Commit to pay the minimum payment on every debt.
- Now look at your smallest debt. Decide how much more money you can afford to spend on it.
- Pay the minimum payment on all your debts, plus that little extra on your smallest debt until your smallest debt is paid off.
- Once the debt is completely paid off, add the minimum payment, plus the extra you were giving to that debt, to the minimum payment of your second smallest debt. Now apply that to paying off your second smallest debt until your second one is completely paid off.
- Rinse and repeat.
Why it works: This theory is based on human psychology. The smallest step is the easiest to take first. Once you’ve started, you’ll see the number of your bills shrinking one by one, and it’s a reward in of itself, giving constant positive feedback on the awesome progress you’re making.
The Avalanche Method
The Avalanche Method of paying off your debt is also pretty popular, but it lacks the instant gratification of the Snowball Method. But, if you’re more laid-back and analytical, it probably works for you. Here’s the basic steps:
- List your debts in descending order, from largest interest rate to smallest interest rate.
- Record the minimum payment on each separate debt.
- Add up your total minimums and commit to paying them each month.
- Now, figure out how much extra money you can afford to spend on your debt each month.
- Take that extra, and focus it on one individual debt, starting with the debt with the highest interest rate. When you’ve paid your first debt off, just like the snowball method, roll the minimum payment plus the extra money of your first debt onto the minimum payment of your next debt, and pay that bill until your second debt is paid off.
- Rinse and repeat until your debt is gone.
Why it works: knocking out your debts with the highest interest rates first saves you hundreds of dollars in interest in the long run, meaning you have more money to spend on eliminating your debt faster. So, it’s an extremely efficient way to become debt-free.
Let’s recap. You’ve got debt. You have to confront that debt, then change the bad habits that got you into debt in the first place, live within your means, and then choose a strategy to start paying your debt off.
Once your debt is gone, you’ll have learned to budget and live within your means and you can finally start saving money, which we’ll cover in detail in the next segment. Good luck!