The four steps to reduce your debt

There are 4 basic steps that will help you get out of debt.

1. Admit that you have a problem and commit yourself to fixing it.

Only you can solve your debt problem. And you can only solve it if you decide that it’s a problem worth solving.

There are a few ways of making that commitment. Some experts recommend writing a statement owning up to the problem and signing it. Others suggest that you call a family meeting and have an open discussion of the debts you face. A debt problem is rarely felt or solved by just one person, and the ideas and efforts of every member of the family may be needed to get you back in the black. People often find that this open acknowledgment of a debt problem is a relief to the others in their families. And it usually comes as no surprise.

The other effective way to make a commitment to solving a debt problem is to talk with a financial counselor or attend a meeting of others with debt problems. Talking about a problem pushes you to admit to yourself that you really do need to take action. Knowing that you’ll be expected to talk again to that same person or group and report on your progress is also a powerful incentive to act—and to stay on track once you start. And finding other people who understand your problem and who have come up with ways to deal with similar problems can be a huge relief if you’ve been shouldering this worry yourself for a long time.

2. Stop debt spending.

Take your credit cards, store cards, and gas cards out of your wallet or pocketbook and put them in a drawer at home. Starting right now, get through an entire day without borrowing money or charging anything. Pay cash, write checks, or use a debit or ATM card.

You’ll find that this in itself cuts your spending and pushes you to make only planned purchases. It will also show you what life feels like without debt spending. Most people are surprised at how easy it is to make the switch. Even travel and car rentals can be managed with cash and checks. A bank debit (or ATM) card is an easy alternative. It can be used just like a credit card, but without the debt effect. The money comes right out of your bank account every time you use it. Once you get through today, you can decide about the next day. And if you manage that, take on another day.

After a week or so of no-debt spending, you’ll be ready to make an even bigger commitment. Keeping credit cards in a drawer at home is like closing a gate on a problem and not locking it. If you have a real debt problem, you need to lock the gate. Cut up your credit cards. And cancel the credit reserve or overdraft feature on your checking account. This will feel like a drastic step—like slicing through your safety rope when climbing a steep cliff. But in fact it’s the access to credit that’s the biggest danger to you until you get your debt down to a healthy level. Later on, once your finances are back under control, you can decide to ask for a new copy of one of your cards.

What about emergencies? Before 1970, people got through every imaginable emergency without credit cards. Try to imagine an emergency where a credit card would really make a significant difference. It’s not a hurricane or a flood. It’s not a fire. You’d just get cash from the bank. The only emergency a credit card can help you through is the “emergency” of running out of money in your bank account. What about renting a car? It’s a myth that you need a credit card to rent a car.

A debit card works just as well. And most rental agencies are happy to rent a car if you have good identification (a driver’s license and one or two other forms of ID) and a cash deposit (generally in the range of $75 to $300). It’s a little more trouble than a swipe of a card, and it’s worth making sure of the details in advance, but people do it all the time.

3. Make a spending plan.

A “no debt spending” policy will push you to pay more attention to your spending. The next step is to get a clear picture of that spending and develop a new spending plan.

You might think you already know how you spend your money. You know what your rent or mortgage is. You have a good idea of how much you spend on groceries. You may know how much you spend on transportation or gas. But without tracking your spending, you’ll find you don’t really know where all of your money is going.

If you doubt this, take out a piece of paper and write down how much you made last year. Then total up those big categories of expenses you can track in your head. When you compare what you made to what you spent—at least in this quick measure—you’ll probably find that you should have ended the year with extra cash to put into a savings account. How does that compare with what really happened?

The reason it’s such a valuable exercise to track spending is that we have too many expenses to keep track of in our heads. And it’s the daily cash spending and the extra expenses—like car repairs, meals out, or holiday gifts—that push us into debt spending.

4. Pay down your debts month by month. Pay them off one by one.

The next step is to make a list, using the form on the next page, of all the debt payments you make each month. Include payments on credit cards, store cards, installment loans, home equity loans, payments to repay personal loans to friends and family—payments on everything you owe to anybody. (Don’t include mortgage payments. Like rent, they are a basic housing cost. And unlike your other debts, you can pay off your mortgage at any time by selling your home.)

For each debt, list

• The name of the creditor (the bank, credit card, business, or person to whom you owe money).

• What you normally pay (what you’ll pay this month if it varies).

• The total amount you owe (the exact amount from your most recent bill or statement).

• The annual interest rate that is applied to the balance. (If that interest is set at a special low rate for a limited time, write down the date that it will go up.)

The interest rate may be hard to find. It may be buried within the small type on the back of your bill. If you can’t find it listed on your bill or statement, call the creditor and ask what interest rate is being charged on your account.

Many credit cards have different rates for balance transfers, purchases, and cash advances. Your bill should show how much of your balance falls into each of these categories, and what the interest rate is for each. If you have balances in more than one category, estimate or use a calculator to figure out what the average interest rate is for the entire balance on that card.

Once you write this information on a list, it’s easy to see how big or how small your problem is. Many people with debt problems resist making a list like this because they’re afraid it will show their debts to be frighteningly large. But the surprise is often that the total is smaller than expected. That’s because money worries can push people to inflate their debts to impossible size in their imaginations. Knowing the actual number grounds you in reality and lets you get down to the business of chipping away at your debts to make them smaller and more manageable. When it comes to getting out of debt, knowledge really is power. Now you’re ready to come up with a debt repayment plan. If you can find another $50 or $100 each month to pay toward your debts, you can start to wipe them away—one by one, month by month.

Look back at your monthly spending chart and the amount you decided that your spending plan would save every month. Divide that savings amount in half. This is how much you can add to your debt payments, starting this month. (You’ll put the other half into a savings account as a cushion against any interruption in your income or unexpected expenses. If you already have $2,500 or more in a savings account, then you can apply the entire amount saved from your spending plan to reducing your debt.)

Now look at your list of debts. Choose one to pay off first. It should either be the one with the highest interest rate or the one with the lowest balance. It’s your choice. The one with the highest interest rate is costing you the most every month. You’ll make a bigger impact on your spending if you pay that one off first. But the satisfaction of paying a loan off completely is an important motivation, and that will happen sooner if you choose the loan with the smallest balance.

Starting this month, add your extra debt-payment allowance (the amount you calculated above) to your payment toward the debt you’ve singled out. So if you had been paying the minimum of $20 a month on a credit card bill and you’ve decided you can add $50 to your debt payments, you’ll pay $70 a month toward this card. Keep making your regular monthly payments toward the other debts. You’ll get to them next.

An extra $50 or $100 payment every month may not seem like much, but it makes a huge difference in how long it takes to repay a debt and to the total amount you pay. An extra $50 per month can reduce the time it takes to pay off a $4,000 credit card balance from 45 years to less than six years. And it can reduce the total amount of interest you pay from more that $11,000 to less than $2,000. Paying an extra $100 per month reduces the payoff time to just over three years and the total interest to just over $1,000.

As you focus your repayment efforts on that one debt, you’ll have the satisfaction of seeing the balance shrink over the course of several months until it finally disappears. When that happens, it will be time to move on to the next debt. (As with the first one, you decide whether it’s the loan with the smallest balance or the highest interest rate.) And here’s where the magic of interest rates starts to work in your favor. When you pay off the first debt, you free up the money you were paying in interest on that loan. Now you’ll be able to pay even more each month toward the second debt. And the speed of your repayment plan will begin to pick up.

Let’s say you were paying $70 a month toward the first loan (the $20 minimum payment plus the $50 you added). And let’s suppose the minimum payment on the second loan is $30. You can actually afford to pay $100 a month toward that second loan now (the $70 you were paying toward the first loan, plus the $30 minimum on the second). You just need to keep to your spending plan. You’ll be paying the same amount of money toward your debts, and those debts will be disappearing faster.

Conclusion:

This four-step plan is a sure-fire way to reduce your debts. It’s a strategy that’s worked for thousands of people who have overcome serious debt problems. It’s the basis of the support offered through professional debt counseling and through groups such as Debtors Anonymous. But it’s not a quick fix. It takes time. And it takes your steady commitment to stick with the plan. You may be tempted to skip a month sometimes or to make an exception and charge something on a credit card or store account card. Nobody will stop you. It’s your money, your debt, and your responsibility. But you can see that any slips will set you back and delay the success of the plan. Just as debts can “snowball” and build up to get you in debt trouble, so a debt repayment plan can snowball in the opposite way, picking up speed and becoming easier as you shed more and more of your debt interest payments. So stick with it. And watch as your debt steadily dwindles until it finally disappears.