Tuesday, February 5, 2008

How to Get Out of Debt

The average American household has around $9,200 in credit card debt. And it's not just struggling young families who are saddled with debt; those hoping to retire are borrowing more than ever. As hard as it may seem to dig yourself out of debt, it is possible. To alleviate and ultimately pay off the debt in your life, you must be disciplined, but it is even more crucial to design a plan that you can actually follow. Our How to Get Out of Debt guide will lead you through the necessary steps to become debt-free and stay that way.

Step 1: How Much Debt Are you Actually In?

Total up all your debt. (Creative commons photo by Beau Wade)
Total up all your debt. (Creative commons photo by Beau Wade)
  • Though you might pay the same bills every month, we often lose track of our total amount of debt because it's too painful to face in the aggregate.
  1. Collect all the bills you receive in one month. (Don't forget any payments you make online or that are automatically deducted from your account.)
  2. Add them up.
  3. Use the debt calculator created by CNN Money to figure out how long it will take you to pay off your debt at your current rate.
      • A debt of $6600 (the 2007 American average), at an interest rate of 16% and with monthly minimum payments of 2% would take almost 30 years to pay off, during which time you'll have paid a whopping $11,173.50 in interest.
  4. Make a chart that shows what interest rates you are paying on each of these loans and what the total amount owed is.
  5. Be honest. Denial is a huge part of being in debt. Realize that your total amount owed is a number you will need to wrestle with, not ignore.
  6. Being open with your spouse about debt (especially at the start of the relationship) will also alleviate financial arguments down the line.

Step 2: If You Don't Use it, You Can't Abuse It

Using cash instead of credit cards makes your money harder to part with. (Creative commons photo by Open Democracy)
Using cash instead of credit cards makes your money harder to part with. (Creative commons photo by Open Democracy)
  • While mortgage payments and student loans are considered justifiable loans (they're also tax deductible), credit card debt can be avoided, or at least minimized. Going cold turkey on the credit cards is the only way to stop amassing new debt that will continue to extend your payments.
  1. Use cash. Watching dollars leave your hands and go into someone else's can help you "feel the pain" of spending in a more tangible way than using a credit card can do.
  2. Try taking out a certain amount of cash every week that fits your budget. When you're out of money, you stop spending.
  3. Rely as much as you can on your debit card for any items that cost more than you are willing to carry in your wallet. If you have enough in your account, that is.
  4. Try keeping your credit card(s) in a drawer at home. That way, you'll be forced to think about big purchases before going home to retrieve your card.
  5. Some experts recommend keeping credit cards in even harder to access places, like "a safe-deposit box, maybe, or frozen in a block of ice."
  6. When the holidays roll around, try withdrawing the amount of money you've budgeted on each person in your family in cash. Clip each person's gift money together with a paperclip and a note with his/her name on it, and spend only that much.
  7. The hard truth of credit card debt is that we get into it because we want things we can't afford and somehow talk ourselves into using credit cards thinking that we will either have enough money at the end of the month to pay off our purchases, or we're simply impatient and can't wait to save up for the new, new thing.
  8. The bottom-line is that if you want to get out (and stay out) of debt, particularly of the credit card variety, don't buy what you can't afford.

Get Out of Debt

Step 3: Consolidate

  • Organize your debt to pay balances with the highest interest rates first.
  1. Research all the contracts you are under with any credit cards or other loans and determine your interest rates on each account. You may have this information in the chart you made in Step 1.
  2. When you start your payment plan, you'll want to pay off balances with the highest interest rates first to save more in the long run.

How Many Cards?

Cut back on your total number of credit cards. (Creative commons photo by Mike)
Cut back on your total number of credit cards. (Creative commons photo by Mike)
  1. First ask yourself, how many credit cards do I have?
  2. Don't forget to include department store cards, which often charge a very high interest rate (around 20% or more!) or gas cards.
  3. Also figure out how much you pay to keep those cards. With so many offers for no-annual-fee cards, you should get terrific benefits from an annual fee card in order to justify keeping it.
  4. Don't be tempted by discount offers from department store cards or same-as-cash financing unless you know you can make payments in full.
  5. Most Americans have between 10 and 15 credit cards. Some have as many as 45 or 50.
  6. While there is no perfect number of cards, it is generally recommended that individuals:
      1. Have no more than one favorite-store credit card. These cards usually come with high interest rates and no benefits to your credit score because they are so easily obtained.
      2. 2 to 6 credit cards is a generally a good number.
      3. Of those, you should probably have a MasterCard, Visa, and/or an American Express card, since these are the most frequently accepted cards.
      4. For cards you can usually pay off every month, find programs that will give you air miles or other bonuses so you are actually getting a benefit from your credit card.
      5. But do be careful closing accounts, because this could have a negative effect on your credit score.

Transfer Balances to Your Lowest Interest Rate Cards

  1. Examine what card charges you the highest interest rate.
  2. Transfer balances from the highest interest rate card to the card(s) with the lowest interest rate(s).
  3. Consider opening an account that offers you a 0% APR introductory period, or another very low rate.
  4. But be sure to check the fine print: if associated fees are high, you could be paying as much as you would have in interest on the other card. And make sure you aren't heavily penalized for one late payment.
  5. And make sure to avoid a card that doesn't jump to a very high APR in only a few months.

NOTE: Remember that applying for new credit cards will affect your credit score. If you don't think you have very good credit and are unlikely to be approved for a new card, it's not worth it.

Request a Lower Rate

  1. If you can't transfer balances or open a new card, at least try to get your credit card company to lower your current rate.
  2. Because it is advantageous for credit card companies to keep their customers (especially those with high balances they pay over time—this is how the credit card companies make all their money), many are likely to lower your rate if you threaten to close your account.
  3. If you have trouble getting your rate lowered, ask to speak with a supervisor. Again threaten to move your balance to a competitor's card.
  4. If you have a credit score of 750, you should be able to get a rate of 10% or under.
  5. Even if you can't get your rate lowered, you might convince a card carrier to waive your annual fee.

Step 4: Pay Up

  • The more of your debt you can pay down, the quicker it will disappear, and with a lower overall cost to you.

Pay More Than the Minimum

  1. Pay as much as you can every month—not just the minimum balance. If you've drawn up a budget, you should be able to figure out exactly how much you can afford to pay each month.
  2. Go back to your debt calculator to see the difference you can make by paying more than the minimum.
      • Remember your $6600 debt at 16% interest? Paying the minimum balance (2%) would get you out of debt in 30 years after making over $13,000 in interest payments. If you doubled your minimum payment, you'd be out of debt in 2 years and seven months, and you will have paid only $1351 in interest!
  3. To pay down debt systematically, pay as much as you can toward your highest interest rate card while paying the minimum balance on other, lower rate cards. Once that is paid off, pay as much as you can towards the next highest interest rate card while paying the minimum balance on other cards, and so on.

FACT:A $1000 purchase paid back at 2% per month (the average minimum payment term) on a card charging 18% interest will ultimately cost $1803.

Don't Be Late!

  1. Late payment fees not only add up (they usually range from $30-$50 per late fee), but lateness can also allow your credit card company to raise your rate.
  2. You'll also have less bargaining power when you try to lower your rate if you've made late payments.

Make it Automatic

  1. Consider setting up automatic payments so you never make late payments and can't wimp out when your bill arrives.
  2. With student loan payments you often get a reduction in your interest rate if you sign up for auto-pay.
  3. If your employer offers the service, have money taken directly from your paycheck and deposited into a savings account. Then use that amount to pay down debt. You usually won't miss money taken out ahead of time.

Find Extra Money to Pay Down Debt

What's your "Latte Factor"? (Creative commons photo by Steve Webel)
What's your "Latte Factor"? (Creative commons photo by Steve Webel)
  1. Determine your "Latte Factor." If you took the $10 a day you spend on coffee (or magazines, cigarettes, etc.) and use it to pay down your debt instead, in one year you'd be able to pay $3600 to creditors.
  2. Write down everything you spend for a week (or a month if you have the discipline) and analyze your expenses. Anything that isn't a necessity could be re-channeled to paying down debt. Do you (or your waistline) really need that daily muffin? Some extraneous expenses you could probably switch up or live without:
      • Expensive coffee: try brewing it at home to save hundreds of dollars a year.
      • Magazines at the newsstand: buy a subscription to slash the cover price on any periodicals you buy more than a couple times a year. Better yet, read them at the library.
      • Takeout lunch: make and bring your lunch from home. You'll save money and calories.
      • Bottled water: buy a water bottle you like and fill it with ice and water from your tap. Not only is this a huge money saver, but it's hugely better for the environment.
      • New hardcover books: wait for them to come out in paperback. Or buy them used just as easily on Amazon.
      • See more money-saving tips in Mahalo's How to Save Money and How to Curb Your Spending.
  3. If cutting back on discretionary spending isn't getting you too far, try to reduce household expenses: can you use fewer minutes on your cell phone? Refinance your mortgage? Lower your energy bill?
  4. Use any windfalls you receive to make additional payments.
  5. Don't use all your extra money to pay off your mortgage if you have other debt. Mortgages usually have lower interest rates, and your payments are tax deductible up to the first $1 million.
  6. Use your savings to pay down debt. If your savings account is only earning you 1-2% in interest (which is average), it makes no sense to have that money sitting around while you're paying 15-16% interest on your debt.
    • Yes, it's good to have a small cushion for emergencies, but use whatever savings you can part with to pay off debt.
  7. And when you pay down debt, when it's time for the next big purchase, you will qualify for a lower interest rate because you have improved your credit score.

Step 5: Form Good Spending Habits

Every little bit helps! (Creative commons photo by Nic McPhee)
Every little bit helps! (Creative commons photo by Nic McPhee)
  • Overspending got you into this mess, right? Learning to restrict your spending and to focus on saving is the ultimate solution to getting, and staying, out of debt.
  1. Think about what you buy before you buy it. Can you really afford it? Do you truly need it? Is there a less expensive alternative that won't compromise your enjoyment of the product?
  2. Stick with your budget.
  3. If you find yourself straying from the budget, try writing down all your expenses for a period of time. Sometimes just seeing them on paper makes you realize what you can live without. It's not so different from dieters writing down everything they eat for a month and realizing that the afternoon cookie isn't doing them any favors.
  4. Request credit reports regularly to see where you're at (and to ensure you haven't suffered identity theft). Seeing areas you can improve may motivate you to keep paying down debt and curb spending.
  5. It may sound trite, but enjoy the little things. If you had to put a price on your experiences, it would probably be safe to say that time spent with family or the perfect day at the beach are "worth" a lot more to you than that new sweater. Keep this in mind when contemplating the things you think you want in life.

Step 6: Seek Out Help

  • If you just can't go it alone, it may be time to seek out a debt counselor.
  1. Find an agency that is a member of the National Foundation for Credit Counseling (NFCC) or the Association of Independent Consumer Credit Counseling Agencies (AICCCA), the two most respected associations of credit counseling services.
  2. When contacting a potential debt counselor, make sure to ask about associated fees and exactly how they will be billed.
  3. If you work with a debt counselor, he will likely determine a set amount for you to pay each month, which he will then distribute to your various debts.
  4. Debt counseling services are a good last resort for those who just can't discipline themselves to make proper payments to their various debts.
  5. Just make sure you aren't paying more in the long run by using one of these services, or that if you are, it is an amount you feel is reasonable for the service provided.
  6. You might also seek out a debt support group to get help from those in a similar situation.

Resources for How to Get Out of Debt

Debt Stories

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