How to Get Out of Debt
by Gregory Karp
Excerpted with permission from The 1-2-3 Money Plan: The Three Most Important Steps to Saving and Spending Smart by Gregory Karp (FT Press; $17.99)
Here's a newsflash: The first step to getting out of debt is to stop adding to it. You do that by saying "no" to a series of payments with interest and, instead, paying in full.
The TV show Saturday Night Live a few years ago aired a skit with comedian Steve Martin, who was guest-hosting. It was a spoof on an infomercial promoting a revolutionary get-out-of debt plan. The "unique program" was titled, "Don't buy stuff you cannot afford."
The skit opened with a discouraged couple sitting at their kitchen table wondering how they'll ever get out of debt. Enter the author of a one-page book, Don't Buy Stuff You Cannot Afford.
Woman reads aloud from the book: "If you do not have any money, you should not buy anything."
Woman to husband: "There's a whole section here on buying expensive things using money you save."
Couple looks thoroughly confused.
Woman: "What if I want something but I don't have any money?"
Author: "You don't buy it!"
Man: "Let's say I don't have enough money to buy something. Should I buy it anyway?"
Woman: "What if you have the money, can you buy something?"
This skit goes on, but you get the idea. The spoof infomercial says if you order now, you can receive the additional book, Seriously, If You Don't Have the Money, Don't Buy it, along with a 12-month subscription to Stop Buying Stuff magazine.
The point is to stop the buying and borrowing behavior that got you into debt in the first place.
How to Get Out of Debt, 1-2-3
- Quit borrowing money.
- Quit saving money.
- Pay small debts first.
1. Quit Borrowing Money
If your debt is growing, there are only two explanations. You're spending too much money. Or, you have an income problem. You're charging necessities on the card because you don't make enough money to cover bare living expenses. Figuring out the reason for running up credit card debt is the first step toward making sure it doesn't happen again.
The culprit of debt is often credit cards. If you can't trust yourself with credit cards, stop using them (cut them up, freeze them in a block of ice in your freezer, whatever). Just don't close accounts because that will hurt your credit score.
Well-meaning people will advise you to transfer balances to lower-rate cards or continually surf the balance from low introductory rate to low introductory rate. Card surfing is not inherently bad, but it's not nearly as effective as actually paying down the card balances. Surfing merely shuffles debt around. And you might even add to debt by incurring transfer fees.
For people in deep debt, it's like the old metaphor of rearranging deck chairs on the Titanic. It doesn't address that sinking feeling.
So, unless you have a credit card at more than 20 percent interest and can get a substantially lower rate, focus your energy on paying more and surfing less. This is one case where "throwing money at the problem" actually works.
2. Quit Saving Money
This might be surprising advice. After all, saving money is a good thing, right?
The problem is your debts are probably costing you more than your savings are earning for you. For example, you might be paying 18 percent interest on your credit card debt and earning less than 5 percent on savings. That's a huge net loss.
In a simple-interest example, depositing $5,000 in a 5 percent savings account earns you $250 a year, which the government then taxes. But if you used that $5,000 to pay down an 18 percent-interest credit card, you save $900. And you pay no tax on that kind of savings.
In fact, after you have a starter emergency fund of $2,500, you can use other saved money to pay off high-interest debt. Again, it makes no sense to have a certificate of deposit earning 5 or 6 percent while paying double-digit interest on debt.
A possible exception to the "Quit Saving" rule is if you have an automatic retirement savings plan, such as a 401(k), 403(b), or automatic deposits to a Roth IRA. If that kind of plan is already on autopilot with 10 percent or less of your income, you can leave it alone. A definite exception is if your employer matches your contributions in a retirement plan. You want to capture all of that free money you can.
However, if you can get intense about paying off your debt, stopping retirement savings for a short time will get you out of debt faster.
3. Pay Small Debts First
How do you prioritize which debts to pay extra on? The biggest debt or smallest debt? Highest interest rate or lowest? I like a hybrid plan that goes like this:
- Pay off debts of less than $1,000 first, from smallest to largest, while paying minimums on other debts.
- Then, pay off debts greater than $1,000 from highest interest rate to lowest, while paying minimums on others.
Each time you kill off a debt, you apply that payment to the next debt. When that's done, you roll the combined total into the next debt, and so on. That's the debt snowball.
This debt-repayment plan is a modified version of a plan espoused by Dave Ramsey, a radio-show host and author of The Total Money Makeover. He didn't invent the idea of paying debts smallest to largest and snowballing them, but he's best known for it.
Of course, mathematics says you should pay the highest interest-rate debts first to avoid paying the most interest. This is easy to understand and logical.
But getting out of debt is a lot like dieting. It's difficult and takes a huge helping of self-discipline. By paying off small debts first, you can wipe out a number of them and feel like you're gaining traction and succeeding. It's the atta-boy or atta-girl to help you keep going and pay off more debt, just like losing a few pounds during the first days of a diet. It gives you encouragement to continue.
So much with money has more to do with what's between our ears than what's in our wallets. The emotional lift from wiping out small debts is well worth whatever small amount of interest you might have saved by paying first on a huge high-interest debt that takes years to eliminate. Just make sure to get rid of those small debts quickly.
Once you get to your large debts, you'll be better off paying more attention to the interest rate. For example, you would pay off a $10,000 credit-card balance at 18 percent before paying off a $9,000 auto loan at 7 percent.
Greg Karp is the author of The 1-2-3 Money Plan. You can learn more from Greg by checking out his blog at gregkarp.com
Take the Next Step:
- Learn how to make a budget.
- Concerned about your job? Learn about preparing for a layoff.
- Read about declaring bankruptcy.
Share your thoughts about this article with the editor: Click Here
Also in Critical Condition
- What is the truth about Chapter 7 bankruptcy?
- New ways to sell your stuff online
- Help affording pet supplies
- Frugal doesn't always mean getting the cheapest
- The value of free
- The essential starting point to lower summer energy bills
- Sick of medical debt? 9 ways to break free
- 5 ways to rebound from a financial disaster
- Is my 401(k) protected from debt collectors?
- 10 steps to take before bankruptcy
- Can stigma of bankruptcy hurt a job hunt?
- 6 risky ways to pay off your credit card debt
- Reduce your debt with this free debt course by The Dollar Stretcher
- Reduce your debt payoff time
- Calculate the real cost of your debt
- Debt pay-down calculator
- Calculate the true cost of paying just the minimum
- Reduce credit card debt calculator