How to Get Out of Debt
Monday, Dec 14 2020
Debt – there’s a reason why it’s a four-lettered word. We hate to think about debt and it’s often a source of a lot of stress. That said, knowing the different types of debt, establishing a budget, and how to get out of debt has financial, physical, and mental benefits.
Good vs. Bad Debt
Not all debt is bad. A simple rule of thumb is if the debt increases your net worth or has future value, it’s good debt. If the debt doesn’t do these things and you don’t have the cash to pay for it, it’s bad debt.
Good debt is a useful financial tool to help you improve your finances in the long run. By contrast, bad debt weighs you down with interest payments while doing nothing to increase your income.
Good Debt
Good debt is debt that helps you get ahead and increase your net worth. A few worthwhile debts are:
- Debt for education. College education and technical training can help advance your career and increase your likelihood of getting a good-paying job.
Taking on debt to expand your education can provide you many advantages. You’ll need to be cautious of taking on too much educational debt. Before starting a program, you should understand the average income after completion of the degree or certification.
You’ll need to weigh how much it costs to obtain the degree, compared to your job prospects after you have completed the training.
- Debt for small business loans. If your goal is to own a business you may need to take on debt to get started. Starting a business takes a lot of planning and hard work but your chances of success improve if you’re knowledgeable about the field of work.
- Debt for real estate. Most people need to take on debt when they buy a house. Over the long-term, if you stay in your home, it’s likely to sell for more than you paid for it. Real estate can also be used to generate income. You can decide to lease part of your primary residence or buy a property to rent out.
Bad Debt
While good debt has the potential to increase a person’s net worth, bad debt does the opposite. Bad debt investments don’t generate income and they won’t go up in value.
Common examples of bad debts include:
- Debt for car finance. We’re not talking about classic investment cars but rather the ones that get you to and from school or work every day. New cars cost a lot of money and they are great but only if you can afford one. If you can’t afford a new car, find a reliable (and hopefully inexpensive) one so you can pay for it in cash or by taking out a small auto loan.
- Debt for clothes, services, and other goods. Clothes, vacations, groceries, and gasoline are all items commonly bought with borrowed money. Although necessary these items add up and provide no return on your investment.
- Debt for credit cards. If you can’t pay your credit card balance in full every month, interest payments prolong and increase the debt amount. Credit card interest rates are often higher than the rates on consumer loans and often lead to a lot of debt.
Why You Should Get Out of Debt
One of the worst things about being in debt is the risk it brings into your life. If you’re in debt, it’s unlikely that you have an emergency fund to fall back on if something happens. This can put you at high risk if you have a setback – such as losing your job or a medical crisis. Being debt-free gives you room to breathe so you don’t have to worry as much about a single event ruining your financial life.
Financial Benefits
Your credit score is impacted by your credit card and loans, and how close you are to your limits. A low credit score can cost you thousands in higher interest rates and make it harder to get out of debt.
The alternative, a good credit score, can provide you access to better interest rates on future loans, lower your insurance premiums, and assist with housing since some landlords do credit checks.
Physical and Mental Benefits
Living with debt can be a source of physical and mental setbacks. Studies show that people with debt are more likely to face problems including:
- Anxiety and depression
- Panic disorders
- Weight gain
- Digestive issues
- Headaches
- Insomnia or sleeping too much
- Alcohol or drug abuse
Getting out of debt can help to eliminate the many physical and mental problems people in debt face.
Relationships Benefits
Being in debt can strain relationships. When you’re worried about paying bills it makes it harder to be there for others and have strong relationships. Getting rid of debt can lead to a happier life and better relationships with your spouse, kids, friends, and coworkers.
How to Get Out of Debt -10 Steps
Understanding how to get out of debt is important but you also need to know that it doesn’t happen overnight.
If you’re overwhelmed by debt, it’s tempting to be an ostrich and put your head in the sand. Facing what you owe can be intimidating and overwhelming at points, but if you’re going to tackle your debt you need to have a clear overview of what you’re facing.
Step 1. Determine How Much You Owe
The first step in knowing how to get out of debt is determining what you owe. It’s important to have one place where you have every debt listed.
Sit and write down all your debts. This would be a complete list of credit card debt, medical bills, loans, and other bills. You need to document balances, interest rates, late fees, and any possible penalties you might have to pay.
Having this information in one place will give you a full overview of the situation you’re facing and will help you decide how to budget and tackle your debt.
Step 2. Create a Budget
A budget lets you see exactly where your income is coming from and where it’s going. Start by listing all your sources of income.
Next, list all your expenses. Expenses are categorized into fixed and variable. Fixed expenses are ones that are the same amount every month and are difficult to adjust. They include things such as taxes, rent, and insurance.
Variable expenses, as the name implies, vary per month and you have a greater influence on their total. Variable expenses are often discretionary expenses although some may be necessities. Variable expenses would include food, clothing, and cell service.
Step 3. Decide Where you Can Cut Back
Review your budget to see where you’re spending too much money and where you can cut back. Here are some ideas:
- Cook at home rather than eating out
- Save money on gas and car maintenance by taking public transportation
- Clip coupons for food and toiletries
- Pause or unsubscribe from services you don’t use – such as YouTubeTV or your landline
- Cut your cable subscription
- Look for better cell phone and internet service
- Look for used items first – including clothes
Once you have determined your income, fixed expenses, and variable expenses subtract the difference between your income and expenses. The remainder is how much cash you can set aside every month for paying off your debt.
Step 4. Don’t Take on Additional Debt
This one might sound obvious – taking on new debt while you’re attempting to get out of debt is counterintuitive. Avoid opening additional credit cards, taking out personal loans, or taking out a second mortgage.
Debt consolidation, however, maybe a good choice for you. We’ll go into that a little later.
Step 5. Decide How to Pay Off Your Debt
Deciding how to get out of debt is the next important step in getting your personal finances in order. Different people choose to tackle debt in different ways. The two primary ways to pay off debt are the avalanche or snowball method.
The Avalanche Method
With the avalanche method, you pay the balance with the highest interest rate first. Once that debt is paid off you move down and pay the debt with the next highest interest until you have paid off all your debt. For example, say you have the following debts:
- $13,000 credit card debt at 17.98%
- $7,500 car loan at 5.27%
- $15,000 student loan at 4.66%
Using the avalanche method you would pay off your credit card debt first. An advantage to using the avalanche method is it saves you money on interest payments. For individuals with larger amounts of debt, the avalanche method can also reduce the time it takes to pay off the debt by a few months.
The Snowball Method
The snowball method is when you pay the smallest debt first and work your way up to the biggest one, like a snowball gathering speed down a hill. Using the example above, you would tackle the car loan first, followed by the credit card and student loans.
Although you end up paying more in interest with this technique you can gain inspiration and momentum from removing one of the debts from your list.
Don’t know which one is right for you? Look at our post showing the difference between avalanche and snowball method.
Step 6. Earn Extra Money
Besides reducing expenses another good way to dealing with debt is to increase your income:
- Change jobs
- Request a raise at your current job
- Get a freelance gig – pick up freelance writing work, drive for Uber or dog walk.
- Tutor
- Rent your car out through services like Avail or GetAround
- Rent out a room in your house via Airbnb or VRBO
- Sell your stuff on eBay, at consignment shops, or have a good old-fashioned yard sale
Step 7. Consider Consolidating Your Debt
Debt consolidation is when you roll multiple debts, typically high-interest debt such as credit card bills, into a single payment. Debt consolidation is something to consider if it allows you to reduce your current interest rates.
A good example of when this may be an option for you is if you have multiple credit cards with interest rates ranging from 18.99% to 24.99%. You currently make your monthly payments on time, so you have a good credit score. You might qualify for an unsecured debt consolidation loan — at a significantly lower interest rate. This saves you money in interest payments and makes it easier to manage by having just one monthly payment.
Step 8. Consider a Balance Transfer
If you are on a low income and you are trying to get out of debt, another option is to get a balance transfer credit card. This is when you move the balance of one credit card to a second new credit card. This is a way to effectively pay off the outstanding balance.
Personal Loans Through FFCU
Focus Federal Credit Union offers Personal Loans to our members to meet their financial needs. We offer competitive rates and flexible terms that can help you consolidate your debts and become debt-free!