How to Get out of Debt in 6 Steps
Use these tips for getting out of debt to improve your finances
If you're overwhelmed by how much you owe creditors, you may be wondering how to get out of debt.
There are many benefits to getting out of debt. When you carry debt year after year, you put yourself in a financially vulnerable position where you have a negative net worth. By getting out of debt, you free up money that you can then use to grow your wealth. Your debt can also limit your opportunities. Being debt-free gives you the freedom to pursue a more rewarding career opportunity or to start your own business.
Create a Budget
If you don't already have one, the first step of getting out of debt is to develop a budget—a plan for how to spend your money every month that takes into account how much you make and how much you earn.
Write down the income from all your income sources. Likewise, record the fixed expenses that remain the same each month, such as your mortgage or car payment, along with the variable expenses that change each month, including dining and entertainment expenses.
Then, subtract your expenses from your income; whatever is left over is your discretionary allowance. Allocate a portion of this amount every month to pay down debt.
If the amount is less than zero, you are spending more than you earn, so you first need to earn more or spend less to create the financial cushion in your budget needed to comfortably pay down debt while meeting other important financial obligations.
Set up a Debt Payment Plan
Assuming that your budget affords you enough discretionary spending, you can set up a debt payment plan. A good debt payment plan will help you to concentrate the money that you are currently paying on debt and speed up the time that it takes to eliminate all your debts.
Start by compiling a list of the different types of debt you hold and your monthly payment on each, such as mortgage, car, and student loans, along with credit card debt. Add up the payments to figure the total amount you need to pay every month to stay current on your debt. If the amount is less than your discretionary spending amount, determine how much more money you can put toward debt each month; if you pay only the minimum amount, it will take a long time to pay off your debt.
This exercise will help you identify and prioritize paying down the largest sources of debt and also track your progress, which will motivate you to continue to get out of debt. As you make extra payments, familiarize yourself with your bank's extra payment policy so that you make the most of your extra payments each month.
If, however, the amount you owe is more than your discretionary allowance, you'll need to cut spending or boost income to make larger or more frequent debt payments. Consider requesting a raise, taking on an extra job, or selling items you own to find money to spend on debt repayment.
Lower Your Interest Rates
High interest rates make it even more difficult to pay off your debt, so one of the best strategies for getting out of debt is to try to lower the interest rates on your debts. There are three ways to accomplish this.
The first approach is the easiest: Contact your creditor and ask for a lower interest rate—either temporarily or permanently. Having a record of on-time payments can increase your odds of success.
Failing that approach to quickly get out of debt, transfer high-interest credit card debt to low-interest debt using a balance transfer card. These cards offer a lower interest rate or even no interest during a promotional period, making it easier to pay off your credit cards more quickly. However, the transfer often comes with a fee, the interest rate may go up once the promotional period elapses, and you could wind up deeper in debt if you continue to spend on the card. For this reason, only choose this option if you have the discipline not to put additional spending on the card and if you intend to pay off your debt before the end of the promotional period.
Lastly, consider debt consolidation—merging multiple debts into a single monthly payment with a lower interest rate. A few common approaches for consolidating debt are to obtain a special type of loan known as a debt consolidation loan or to work with a non-profit credit counseling firm as part of a debt management plan; the counselor will negotiate with your creditors on your behalf to secure lower interest rates. However, you will still have to pay back the principal.
All three of these strategies can help you speed up the process of getting out of debt.
Lower Your Debt-to-Income Ratio
The amount you owe relative to the amount you earn is known as your debt-to-income ratio. It is often a good indicator of your financial situation—particularly whether you have overextended yourself credit-wise. It's important to maintain a low debt-to-income ratio—under 30% is recommended, but under 7% can help you land an even higher credit score.
Your debt-to-income ratio can also dictate the type of home loan that you qualify for. For example, many lenders like to see a ratio of under 36%. If you have a debt-to-income ratio of higher than 30%, work on lowering that number as quickly as possible. You can do so by paying down your debt and not taking on debt through new credit cards or loans. However, increasing your income is another way to lower the ratio.
Pay Down or Settle Old Debts
If you've been carrying around certain debts for a long period of time, especially bad debts that don't have value or depreciate in value, it's preferable to pay them off in full, as accounts that are shown as "paid in full" on your credit report help your credit score.
However, in the event that you can't repay them, you may decide to settle your debt—that is, work with a debt settlement company to negotiate payments that amount to anywhere between 50% to 80% of your outstanding balance. While the company negotiates with your creditors, you make no payments, and then the company makes payments on your behalf.
However, while you wait for the negotiation of the settlement to take place, you'll get calls from creditors, and the late payments will stay on your credit reports for seven years, damaging your credit score. Even if you don't incur late payments, the settled account can stay on your credit report for seven years. In addition, the service comes with a fee of anywhere from 15% to 25% of the settled amount. You will also need to pay taxes on any amount that is forgiven, so you will need to set aside money for that as well. Even so, settling an old debt is better than letting the account go delinquent or defaulting on it.
A debt settlement company is different from a credit counseling company you work with as part of a debt management program; the latter doesn't impact your credit score, whereas settling a debt does.
Stop Using Credit Cards
Once you start paying down debt, it's important to avoid going deeper into debt by abandoning the bad habits that got you into debt in the first place.
One of the habits is excessive credit card spending. To curb your spending, stop using your credit cards each month. This can be a difficult process, especially if you find yourself using them every month to cover shortfalls. However, armed with a budget, you can find ways to pay for expenses in other ways.
For example, you can use cash or debit cards, or draw from savings accounts you built up for certain purposes, such as an emergency fund or goal-oriented savings accounts for a house or car.
If you still can't curtail your credit card spending, leave your card at home in an accessible location so that you can't use it when the impulse to buy hits. Some truly determined individuals even freeze their cards in a block of ice. It could take hours to thaw when you need it again, but drastic measures may just help you get out of debt and reclaim your financial freedom.