If you really want to reduce your debt, the first thing you will need to do is create a spending plan, then stick to it. Your spending plan, or budget, needs to focus on paying down your debt and not adding to it. This may mean cutting up the credit cards and avoiding sales and bargains that are too good to be true. Set your primary financial goal to be out of debt in six months, a year, two, or whatever it takes. Write it down. You need to stick to this plan until you have achieved your goal.
Identify and prioritize essential expenses. Limit your spending to the bare essentials: food, shelter, utilities, etc. It may be difficult to define what is essential and what is "luxury," but if you are to get out of debt, you must be tough. Make a list of essential expenses and how much they cost on average each month. Do not forget those expenses you pay only once or twice a year, such as insurance premiums or property taxes. If you can economize and reduce some monthly expenses, do that. You may reduce utility bills by carefully adjusting the temperature in your home by raising the thermostat in summer and lowering it in winter. Turn lights off in rooms when no one is in them. Spend less time on the telephone. Avoid expensive convenience foods and buy raw ingredients to prepare less expensive, more nutritious meals. Make gifts instead of buying expensive items to give away during holidays and for special occasions. If you set your mind to it, you can come up with many ideas that may save you pennies a day, which add up to dollars you can use to reduce your debt.
Write your expenses down. Write down how much they cost each month. Once you make your list, do not buy anything that is not on it until you reduce your minimum debt payments to below 15% of take-home pay.
By the way, your monthly debt payments are not expenses. Except for your mortgage payment, which is like rent, debt payments are the ghosts of prior months' expenses you incurred when you did not have enough cash to pay for them. Furthermore, they are causing you to pay more and more for those prior expenses because they have hidden expenses—interest and finance charges.
Make a list of all your take-home income. This is what you have available to pay your debts and essential expenses. Do you usually get a large income tax return each year? If so, adjust your withholding at work so you get the money each month when you need it.
Now deduct your monthly debt payments (except your mortgage) from your income. This is what you have left to pay essential expenses. Here is where many get into trouble. If you find that you do not have enough to pay debts and expenses, you will need to take additional action. Some people simply start juggling debt payments by making minimum credit card payments or paying one bill this month and another the next. This is a bad move.
Revisit economizing. Look at those expenses again. Economize where you can. When you get to the point where you simply cannot cut expenses any further, you have one of two choices: earn more income or lower your monthly debt payments. It might be necessary to take another job, or have a non-working spouse take a job to bring in additional household income. Lottery tickets and casinos won't do it—do not waste money. Reducing your monthly debt payments is a little trickier. Avoid the temptation to juggle payments—that only costs more in the long run, and it may damage your credit rating.
If you set a priority of being out of debt by a certain date, you will need to determine how much you must pay each month until that date to reduce your debt payments below 15% of your take-home pay. This is particularly important if you have a lot of installment credit or credit card debt. To calculate this amount, you will need a financial calculator. You can find free financial calculators on many Websites or in financial software you may already own. In the following paragraphs are the basics to determine how much you should be paying each month to eliminate your debt by your target date:
Determine how much debt you want to eliminate by the target date—this is the principal (P). For example, suppose you have several credit cards totaling $10,000 and a student loan balance of $10,000. If you only want to pay off all the credit cards and half the student loan in three years (you feel you can manage the rest of the student loan later), your principal will be $15,000.
Determine an interest rate to use. The highest rate from all your loans might be the best one to use, as it will help you calculate your way out of debt faster. Let's say that you have one credit card balance with $7,000 at 15%, another with $3,000 at 7%, and the student loan ($10,000) at 3%. Choosing 15% as the rate (R) will help you calculate payments to most quickly reduce your debt. Of course, you could use a weighted average, but we will leave that for a mathematics textbook to explain.
Set the term (N) as the number of months or years to achieve your goal. In our example, we are using three years or 36 months.
When you plug these numbers into a financial calculator, you will come up with a monthly payment (PMT) equal to approximately $520. This is the number you should use to get out of debt in the time you set as a goal. All you need to do now is to allocate how much of the payment should go toward each of the loans you are paying off. The best way to allocate the payment is to pay off the highest-interest-rate loans faster than the lower-rate loans. In our example, we might allocate the largest amount to the 15% credit card, with lower amounts to the others.
If your calculated payment is still more than you can afford, you will need to consider refinancing methods. However, if this works for you, why not continue to make those larger monthly payments to your savings and investment plans after your debt is gone? This will help you stay out of debt.
This article provided by The Educated Investor and powered by CalcXML.
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