There are three steps to paying off your debt.
1) Create Useful thoughts – which I discussed in the previous blog post.
2) Create a Plan – which I’ll address in this article
3) Execute – coming next week
For this post I’m assuming you are not adding to your debt each month. If you are, consider downloading my free budget template to create a budget and a plan to cover all of your monthly expenses.
I’ve broken step 2, “Create a Plan,” into 4 sub steps
1) Start Saving
2) List All of Your Debt
4) Make a Contingent Plan
1) Start Saving
Though counterintuitive, starting a savings account is the most important thing you can do to pay off your debt. It provides two advantages 1) It lets you cover unexpected emergencies without using debt 2) Seeing your savings grow will provide you with motivation to stay on your plan and continue reducing your debt.
Come up with an amount that you can contribute each month while still making a moderate reduction to your debt. Once you’ve saved enough to cover 1-3 months of living expenses you can reduce this amount to accelerate your debt reduction. But, you should always be contributing a certain amount into savings each month.
2) List All of Your Debt
List all of your debt on a spreadsheet. The PDF download referenced above includes a link to one you can download for free.
Ideally you’ll provide the following information for each loan/debt.
1) Lender or card name – A way to identify the debt (Car loan, Visa, etc)
2) Amount owed
3) Minimum monthly payment
4) Interest rate
Most people’s plan to pay off their debt begins by figuring out how much extra money they have at the end of the month and then applying that to their debt. A more proactive approach is more effective.
Now that all your debt is listed in one place you can look at it proactively decide: 1) Which debt you want to pay off first and 2) How to pay it off.
1) Which to pay off first
Avalanche method – Start with the loan loan that has the highest interest rate. Once that’s paid off move to the next highest. This will be the cheapest method but is quite often discouraging as those loans with higher interest rates can take longer to pay off. This often leads to frustration and giving up.
Snowball Method – Pay off the loan with the smallest balance. Once it’s paid off add it’s minimum monthly payment to your overall debt reduction payment and then work on the next lowest loan. This will likely cost you more but is more effective at reducing your debt as you’re able to see results much sooner.
2) How to Pay if Off
There are numerous sources to pay off your debt. Here are five to consider.
- Cash Flow – The amount of funds you budget each month to apply towards your debt. This can be increased in various was as described in my 9th podcast, “11 Ways to Increase your Net Income.”
- Other Sources – This includes any funds you may have in a savings account, cashing out all or a portion of your retirement account (there are tax penalties for doing this but it may be worth it), and borrowing from family and/or friends.
- Selling Assets – This could include large assets such as a boat, extra car or 2nd home. Selling these items may seem painful now, but they eliminate the operating costs (gas, insurance, parking etc), pay off the debt on those items and usually result in enough funds from the sale to apply towards other debt. With time they are not usually missed and the financial gain can be worth it. Smaller items can be sold online or at a garage sale.
- Renegotiate Loan Terms – Call and ask the lender to lower the interest rate. Some lenders will forgive a portion of the debt if they believe you will not be able to repay the entire loan. There are financial consequences for going this route but again, it can be worth it in the long run.
- Bankruptcy – While this carries a negative stigma it is meant to help people start over financially and can be a good option for some people. Again there are financial consequences to this option. There are two basic types of personal bankruptcy. Chapter 7 – all or part of your debt is wiped out after your liquid assets are discharged. Chapter 13 – All or a portion of the debt is repaid over a 3-5 year period under new terms. Links to additional information is provided in the downloadable PDF.
4) Contingent Plan
Unexpected events will happen, maybe your car will need a repair or a minor medical emergency will happen. Come up with a “Contingent Plan” for these unexpected events. The plan should include the mental and math side of money.
Mental Contingent Plan
Spiralling into negative thoughts such as, “This will never work,” or “See, it can’t be done,” will not serve you. Consider other thoughts such as, “Well, this was just an off month, next month will be better,” or “It couldn’t be helped.” Here are five ways to create new thoughts.
Math Contingent Plan
Unexpected expenses can be paid for via a savings account, borrowing from family or using debt, if needed. Come up with your own ideas.