This month’s Frugal Friday is a big one, but I promise you it’s worth the read! Considering that the total amount of US consumer debt in 2010 was nearly $2.4 trillion (source), I think it’s safe to say that we all have some debt that needs to be paid off.
So if you have thousands in credit card debt, even more in student loans, or you just want to get rid of that personal/car/home loan once and for all, follow these steps to get started on getting rid of that debt!
Step 0 – Create a budget
Sounds boring, I know. But this pre-step is absolutely necessary for you to get on track with your finances! You need to know exactly how much income you’re receiving every month as well as what your mandatory expenses are – that way, you will know exactly how much you can contribute to paying off this debt.
I did a Budgeting 101 post as one of my first posts here, but there are several ways you can actually execute this. I personally use Mint.com to track all my credit cards and accounts and I’ve also created an Excel sheet that helps me track my money on a daily basis.
Once you’ve set up your budget, you can start the first step to your debt repayment!!
Step 1 – Make a list of all of your debts
If you did step 0, then this step shouldn’t be so bad. If you’re using Excel, you should create a separate tab for this and create 4 columns:
- Account name (i.e., Mortgage, Macy’s Credit Card, Car Loan #2)
- Minimum monthly payment
- Current balance owed
- Interest Rate
Items 2-4 should easily be found in your monthly statements. For an example of what this tab should look like in Excel, here’s a fictional debt list of Jane Doe that is very similar to how I’ve set up my own debt tab:
Now, add up all of your minimum payments. In the above example, Jane Doe’s monthly minimum spending on this debt is $2,445.
Step 2 – Pick a repayment plan
Hopefully the amount you can throw at your debt monthly is greater than the monthly minimum payments. If not, then you’ve got to go back to step zero and do some extreme budget cuts, but I won’t go into that right now.
Now, there are two popular ways you can pay off your debt: one way is the avalanche and the other is the snowball.
A debt avalanche is when you pay the minimums on all of your debt and throw any extra available money toward the debt with the highest interest rate. To visualize this, you can do a simple sort of your list in Excel, as I’ve done below for Jane Doe’s debt:
For example, if Jane Doe were to have a total of $2,500 available to pay off her debt, she would pay the minimums on everything (which totals $2,445) and she would throw the extra $55 toward Credit Card #1 every month. Once Credit Card #1 is paid off, she would continue to pay the minimums on everything and she would move all the money that she was previously throwing towards Credit Card #1 to Credit Card #3, since that is now the debt with the highest interest rate. This would continue until the last debt is gone.
A debt snowball is when you pay the minimums on all of your debt and throw any extra available money toward the debt with the smallest balance. Here is what Jane Doe’s list of debt looks like when it is sorted by balance:
Assuming she has $2,500 available (just like the previous example), she would pay the minimums on everything and she would throw the extra money left over toward Car Loan #1, since that debt has the smallest balance. Once Car Loan #1 is eliminated, she would continue to pay the minimums on everything and she would move all of the money she was throwing toward Car Loan #1 and start throwing it toward Credit Card #2, since it is the next debt with the smallest balance.
So which method should you choose?
If you want to pay off your debt with the least amount of interest possible, you should choose the avalanche (in most cases). However, you might not see your first debt paid off until months or even years down the road, which can be very discouraging.
If you want the satisfaction of paying off your first debt as soon as possible, then you should choose the snowball. The snowball is set up for you to have smaller victories sooner, which is meant to be psychologically satisfying and it encourages you to continue!
[Quick note: A great website that can help you calculate just how much interest you would be paying as well as how much time it would take using either the avalanche or snowball method is unbury.me. I hope to do a full review on this website soon.]
Step 3 – Make your payments on time
About 35% of your FICO score is based on your payment history (source). So consistently making your payments in on time (even a few days earlier) would definitely boost your credit score. I’ll go into the importance of a good credit score some other time, but I’m including it as one of my steps to debt repayment for a reason.
Once your FICO score improves in range, you have more leverage in negotiating your current interest rates. If you can decrease your interest rates on one, or even all, of your debts, the amount of interest you pay will greatly decrease and you might even be able to finish your avalanche/snowball sooner than expected!
Step 4 – Snowflake when you can
Financial snowflaking is the idea of throwing any extra savings toward your financial goals – in this case, it would be your debt repayment. For example, if you save $50 on this month’s grocery expenses, that $50 is now a snowflake that you add to your avalanche/snowball.
You can be creative with this – if you’ve budgeted money for going out, challenge yourself to go out only once a week or *gasp* once a month and use those savings toward your avalanche/snowball! Find small ways where you can save and let those snowflakes build up!
Be careful though, some companies charge for early repayment, so be sure to look out for that. To be safe, hold on to your snowflakes until you send in your regular payment to avoid early payment fees.
Step 5 – Be patient!!!
Financial freedom does not happen overnight! This path may take months, or (for most) even years to complete! Don’t get discouraged!!
*whew* Well, there it is – my step-by-step guide to debt repayment!! I know it’s a long journey (believe me, I’ve been there), but I’m right there next to you!! If you have any questions, please feel free to comment and I’ll do my best to help you!