This may be one of the most important units in this resource. If you have accumulated debts beyond the mortgage on your home, you should read this unit. It will guide you through the process of reducing and eventually eliminating your debt. If you are relatively debt free or only carry manageable debt on your residence, you may find a quick read-through helpful.
For most people, getting out of debt and avoiding the associated interest charges will have more impact on their finances than anything else found in this entire resource. The basic rule is really quite simple. You should avoid debt on anything that is likely to decline in value over time or anything that is for immediate consumption. Examples of things that will decline in value over time include cars and furniture. Items acquired for immediate consumption would include things like food, clothing, fuel, and entertainment. You need to work towards a point where you have saved for those types of expenditures in advance and do not need to borrow any money to purchase them. This is not to say that you should never charge items like that to your credit card. Many people do just that but make sure that they pay off their balance in full each month so they never incur any interest charges. By doing this, they have not incurred any debt and are within the suggested guidelines.
The ultimate goal of effective money management is to allocate your income to current and future expenditures and not be burdened by the past. If you have debts, especially debts on items that have already been consumed or that are declining in value with time, interest is working against you. This single factor can prevent you from ever reaching your financial goals. It will add to the cost of everything that you have purchased on credit. It doesn’t make sense to spend a lot of time comparing prices to find the best deals in town and then add to the cost of the items you purchase with unnecessary interest.
There are some types of debt, however, that can actually be helpful for you and your family. The prudent use of this kind of debt is good money management. In the context of future expectations, this could include debt on items that are expected to increase in value over time. The mortgage on the home that you and your family occupy would fall into this category. Over time, real estate tends to increase in value, and your wealth grows as you provide a home. Interest rates on owner-occupied homes are among the lowest available, and in the United States the interest that you pay can be deducted from your income tax. Equity in a home can be used for any number of purposes, and the net worth of individuals who own their home is normally dramatically higher than individuals who rent. More information about this can be found in the unit, Home Ownership.
Another important example of debt that can be beneficial is investment debt. This would include money borrowed to start a business or to acquire an income-producing asset. In both cases, it is the expectation that the income produced from the acquisition will be sufficient to service the loan. Many businesses in the United States are started with home equity loans. While not every business will be successful, many are and the debt is repaid and wealth is created through wise use of debt to finance businesses.
One type of debt that may not appear to fit into either category is money borrowed to finance an education. A college education will usually provide the recipient with greater earning capacity, and a case could be made that the ability to produce a stream of income constitutes an “investment” in the future. Not all of what is needed for education should be borrowed, but student loans are part of the financial package for many families. It is recommended that you go through the information that is presented in the unit, College Planning. Prepare for the expenses that will be associated with educating your children or yourself, and then use loans when they are in your best interest.
Even if you follow this advice on debt, you could still find yourself with more debt than you can afford. Just because something is expected to increase in value does not mean that you can afford the payments associated with it. The mortgage payment on your residence needs to be part of a well thought-out spending plan. Buy a house that comes with payments (and other expenses) that you can afford. Don’t assume that every investment you make will pay enough to service the loan associated with the acquisition. Make sure that if you finance your education through borrowing, you have considered the starting salary that you anticipate earning when you graduate. It will need to be sufficient to service the loans that you are taking out and leave enough to cover your living expenses.
Getting Out of Debt
For many, getting out of debt will not be easy. You are probably in debt because in the past you have spent more than you earned. It may not have been much at any given time. It may have been only a few dollars each week. Over time it adds up and interest begins to accrue. Eventually, you reach a point where you are no longer able to save for the future or even meet the needs of the present, because you are spending so much of your income paying the interest on what you did in the past.
There are three basic strategies for eliminating debt from your life. All three will work, but you need to select the one that you think will work best for you and your family through an informed-decision process. Your decision will depend on what assets you have to bring to the task and how much experience you have with managing money.
All three methods have a couple of things in common. First, you need to enter into this with a certain amount of resolve. Getting out of debt needs to become one of your goals. Those who are in committed relationships will need to make this decision together and then work together to accomplish it. It does not make much sense to have one person trying to pay off debts while the other continues to increase debt. You need to be accountable to each other and work together to accomplish this goal. The decision-making process for single persons is obviously simpler, but it still requires considerable resolve if you are to be successful.
Regardless of how you plan to go about eliminating debt, you need to first get a handle on how much debt you actually are carrying. You need to summarize all of the debts that you have in a form where they can be compared to each other. You will need to know the current outstanding balance, the interest rate, the monthly payment, and the amount of time remaining on the debt. To help determine the time remaining on a debt, use this credit card payoff calculator. Knowing the interest rate on each loan is extremely important. It will allow you to make an informed decision about where you concentrate your payments first. By applying extra money to the debt with the highest interest rate, you will be able to pay off all of the debts faster than if you go about it in some other way.
During the time that you are working your way out of debt, you do need to resolve that you are not going to assume any new debt until you have the whole thing under control. If you are carrying credit card debt, this means that you should quit charging anything until such time as you are able to reduce all of your balances to zero. If you are used to paying for things in this way, this will be the most difficult change that you will need to make. Some people go to some rather extreme lengths to make their own credit cards unavailable to them. Scissors are a rather permanent way to do this. There are people who have even frozen their credit cards in a large block of ice, because they wanted to keep their cards but make them hard to use. When shopping, you need to resolve to leave credit cards at home and agree to not use them until you no longer carry any balance from month to month. Eventually they will become part of the way that you manage your cash.
Pay Off Debt Over Time
Once you have the debts summarized, you need to take a look at what assets you can apply to them immediately. It doesn’t make sense to keep a lot of money in savings earning a relatively low interest rate while paying a relatively high interest rate on consumer debt. Before you implement any of the strategies which follow, you need to take a look at your balance sheet (net worth statement) and determine which of the assets listed there are available to be applied to the outstanding debts immediately. This will accelerate the process of eliminating the debt.
Take a look at how much money you have in savings accounts or in other accounts that can be used without jeopardizing your financial position. Don’t tap money that you expect to be needing before the debt is retired, but do pull together as much cash as you can from whatever sources are available to you. Next, take a look at ways to reduce the amount of interest that you are being charged. While the credit card companies will not be anxious to reduce the rates that they charge, you may be able to tap into other accounts such as cash-value life insurance or certain retirement accounts and borrow enough money at a low rate of interest to pay off some debts completely. Now you will be repaying those new debts but at a much lower rate of interest. The goal here is to tap into whatever assets you may have to reduce your balances and reduce the interest that you are paying. It will shorten the time that it takes to be essentially debt free.
If there are some debts that are relatively small or very near to being retired, you will want to pay them off immediately with the cash (if any) that was generated by what you found. If you are within three months or less of having something paid off, apply the cash to that outstanding debt. This will eliminate one payment and give you more to apply to other debts going forward.
Next, take a look at the interest rate being charged by all of the remaining creditors. You will be making the minimum payment on every account each month except for the one with the highest interest rate. That account gets “special” attention. You will want to pay the minimum plus as much as you can beyond that so the balance is reduced as much as possible. When the next round of monthly bills comes in, repeat the process until the debt to the creditor charging the highest interest rate has been reduced to zero. Then, take a look at the remaining debts and select the one that has the highest interest rate. You will want to repeat this process until all of the debts have been eliminated. There is no magic here. You got into debt by spending more than you earned each month. You get out of debt by spending less than you earn each month and applying it to the debt that you accumulated.
By this time, you will have gained a lot of experience in managing the month-to-month expenditures and will have gained a lot of the skills needed to avoid debt in the future. This is the essence of the sixth principle of A Disciple’s Generous Response: A disciple spends responsibly as a commitment to live in health and harmony with God and the world. Learning the importance of living within our means and learning the appropriate use of debt helps us become disciples who spend responsibly.
Debt Consolidation Loans
If you own a home and have built up equity, there may be a way for you to consolidate your debts into a home equity loan and significantly shorten the time that it will take you to get out of debt. Because home equity loans are secured by your home, the interest rate is usually lower than with other types of loans. In addition, the interest on this type of loan may be tax deductible and will further reduce the impact of the interest rate through lower taxes.
You will need to work with a lender that is willing to lend you money on your home and take out a second mortgage. Shop around for the best type of loan and the best interest rate, and consolidate all or as much of your outstanding debts as possible into one loan and pay it off over time. Avoid the temptation of stretching out the payments for twenty years. The initial term may indeed be twenty years, but you should make extra principal payments whenever you can to reduce the balance as much as possible, as early as possible.
Most lenders will offer you more than the total needed to pay off your credit cards. They are in the business of lending money, and since the loan is secured by the value of your home, they consider it to be a safe loan. Don’t take out more than you need. Resolve to change your spending habits while you pay off the loan so you do not get to the end and find yourself as deep in debt as when you began. Go this route only if you are going to apply the same amount as before consolidation to the debt, or at least apply some of the amount to debt reduction and save the rest.
Consumer Credit Counseling
If neither of these methods will work for you, it is still possible to get out of debt by working with a consumer credit counseling organization. A consumer credit counseling organization is funded primarily by creditors and assists consumers in repaying the money that they have borrowed. For a nominal fee, they will negotiate lower rates and lower payments with your creditors.
Creditors generally like it when you go with a service, because it means that they will be repaid their principal, even if they do not get as much interest as they thought they would get. Phone calls for overdue payments usually stop, and you have the convenience of making one payment per month and having all of the individual payments made on your behalf.
Make sure that you are working with a reputable agency, or you may find that they take your money and don’t make the payments. When it all finally comes to light, you could be in worse shape than you were before. Not-for-profit agencies are normally better than ones that operate for profit. Look at the Web sites at the end of this unit for more information on reputable agencies.
Living within the Spending Plan
Now comes the hard part. Regardless of the method that you have chosen, you need to live within the spending plan you have established. It means that you will have to change the way that you go about living day to day. Find out more about this in the unit, Living within Your Income, and find those strategies that will work for you and you are willing to commit to.
This is a great time to develop some careful spending habits. You will not always have to live in a state of reduced spending, but when it comes to money management there are few things more satisfying than living within your income. You will also be learning how to manage credit so it assists you in reaching your financial goals, rather than work against you as it does for so many.
This needs to be the last option that you consider. It will have an impact on your finances for years into the future. You may not be able to buy a house or finance a car. It may seem that it is an easy way to start over again, but in reality you start all over again in a worse position than before. As a general rule, don’t do it.
One of the first things many people think about when they find they are struggling with debt is the possibility of earning more money by working a second job. While this can certainly be part of the solution, you need to understand that it may not be as helpful as you think.
The additional income that you earn will be subject to taxation. For most people that will mean social security tax and additional state and federal taxes at the highest rate that applies to their income. More of the additional earnings will go to pay taxes (as a percentage of income) than is the case for the money that you earn at your regular job.
Second jobs bring with them additional expenses that may not seem obvious at first but need to be part of the decision-making process. You will need to pay for transportation to and from that job. You may have to purchase additional clothes that are appropriate for the second job. You may not have the time to prepare meals at home and may find you are spending more on convenience food or meals out. If you have children, there will be additional challenges in how they are cared for and raised.
Most importantly, second jobs mean less time with family and friends and will limit the amount of time you have to do the things you really love. While they can be part of the solution, they need to be viewed in light of net income (after taxes and other expenses) and in light of the impact they will have on your family and social life.
The Wise Use of Credit
When considering a purchase you will be financing, you need to pay close attention to the interest rate. Most people only look at the monthly payment, and if they feel that they can afford that, they don’t pay a lot of attention to the interest rate or term. You need to look first at the interest rate, second at the length of time that you will be required to make payments, and finally at the monthly payment.
If you use credit cards as a money management tool, you will need to plan to pay off the total balance each month. This will mean no interest charges and really could be considered “paying with cash” in terms of the impact that it has on your financial situation.
Make it your habit to save for things in advance. If you own things, they will break or wear out, and you need to have a plan as to how you will repair them or replace them when that happens. Create a spending plan that includes regular savings for the ultimate replacement of the things you own. When the time comes to spend the money, you can always decide to finance a purchase if it appears to be in your best interest to do so.
Finally, be aware of the fact that most lenders will lend you more than you can afford to repay comfortably. Ultimately, they are not interested in the quality of your life. They are concerned only with getting repaid. It is up to you to monitor your finances so that family and social life is enhanced by what you do with your money and how you manage your debt. Try to live within the context of your monthly income and never go beyond that.
Consumer Credit Counseling
Additional Help: Printable Forms Included
Credit Card Payoff Calculator
Good $ense Money Management