Debt is like indentured servitude. You work and earn income, but you hand over that income to someone else. With debt, your finances are controlled by someone else, not you. For example, credit card companies have the right to change your interest rate at almost any time with advance notice. In fact, CitiGroup recently raised its interest rates on a wide swath of customers to help bring in more money to this failing company. High interest rates cause customers to take longer to get out of debt because a smaller percentage of their payments goes towards the principal balance. In this case, CitiGroup is controlling a portion of your finances. If a Citi customer is accruing more debt on the credit card at the same time, CitiGroup’s control outweighs the customer’s.
Credit cards aren’t the only forms of debt. Mortgages and student loans prevent people from saving as much money as possible, so even before you make decisions about life goals, it’s a good idea to start eliminating these debt as well.
Good debt versus bad debt
One comment you may hear is that mortgages and student loans are “good debt” while credit cards and car loans are “bad debt.” The philosophy here is that houses appreciate in value, so mortgages provide leverage, allowing you to risk less of your own money for a greater return. Similarly, a college education allows you to earn more money in the future. In reality, houses do not always appreciate in value, especially if you consider how house-related expenses contribute to the true cost of owning a home. Also, not everyone earns more with a college degree than they would without one, but on average, those who do earn more over their lifetime. It is possible, however, to earn a college degree without going into debt.
On an individual level, you can’t use generic labels like “good debt” and “bad debt.” If you are accumulating more debt, all debt is bad. If your debt is not increasing, you have the option of weighing your debt to determine which to pay off quicker. For example, at one point, it was common to have student loans with interest rates under 3%. At the same time, high-yield savings accounts paid over 4%. Even after taxes, it was worthwhile — if the student loan was the only debt — to put extra money in savings while making only the minimum payment towards the student loan. That is not always the case, particularly now that savings interest rates are lower and student loan rates are higher.
Now just get out of debt
Getting out of debt is a six-step process, with one extra preliminary step.
0. Put $1,000 aside. You should be spending less than you earn by now, so you have excess income at the end of every month. Start putting aside some money for emergencies even before you start paying off debt. $1,000 is a good target, but you shouldn’t wait until you reach that point before moving on to the next step. The purpose of this money, which will eventually become your “Emergency Fund,” is to allow you to dip into the savings if a problem comes up. Rather than paying for the surprise expense with a credit card, you have a little accumulation set aside. If you already have a savings account set aside for this type of expense, move right to Step 1.
1. Commit to avoiding new debt. You’ve already committed to taking action to take control of your finances, but in order to do that, you must eliminate your debt. While you have debt, you don’t get to use a portion of the income you earned. You already used income you didn’t have, allowed someone else (a lender or a credit card company) to cover the expense for you, and now they own you (or part of your income). Until this relationship is eliminated, do not accumulate more debt. Do not spend more than you earn by using credit cards. Don’t buy a new car if you don’t have the savings. Once you’re out of debt, you can carefully ease these restrictions, but the object is not not get into debt while you’re going through a process of elimination.
2. Call your creditors. There is no harm in calling the credit card companies to ask for lower rates. The customer service phone number is always printed on the back of credit cards, and this is your first point of contact. Historically, people have had success calling customer service and asking for a lower rate. With the economy deteriorating and many banks and credit card companies struggling, it might be tougher to get them to budge on your interest rates. If at first you don’t succeed, ask for a supervisor. Call back, if you have to. In some cases, the banks will offer to lower your rate if you close your card. That means you will pay less to get out of debt and you’ll be restricted from using that card for more purchases. Take the deal! You won’t be using your credit card again until you’re out of debt, anyway.
3. Choose how to pay back your debts. If you want to spend the least amount of money and least amount of time to pay back all your debts, there is only one option: the Debt Avalanche. It’s kind of like Dave Ramsey’s “Debt Snowball” on steroids. The main difference is that the “Debt Snowball” relies on extrinsic motivation while the Debt Avalanche works the best with intrinsic motivation. If you’ve been following the Take Control of Your Finances series on Consumerism Commentary, and you’re committed to the idea of being in control, you have the intrinsic motivation to use the best option.
The Debt Avalanche specifies that your debts should be listed from top to bottom, sorted by interest rate, with the debt with the highest interest rate on top. The balance is not important. To all your debts on the list, pay the minimum monthly payment, but to the debt on top, pay more than the minimum payment — as much as you have available. If your monthly excess income does not meet the minimum payment requirements across all cards, you will have to call your credit card companies to renegotiate. If you aren’t able to make at least the minimum payments, you may be accruing more debt without spending anything. It’s like a cruel magic trick.
This method works best when “all debts are created equal,” for example, when all debts are credit cards. But it doesn’t always work that way. You may have a loan from a family member. Maintaining good relationships with your family should be a larger goal in life, outside of money. You may want to pay this debt off first, even if the rate is 3% while your credit cards are at 14.9%. This decision is a personal choice. If you decide to pay the loan off faster than your credit cards, move this loan to the top of the list. Pay your minimums to all other debts, but to the loan at the top of the list, pay as much as possible.
Once the debt at the top of the list is eliminated, do a little dance if you are so inclined, cross out the debt, and start putting your excess money towards the debt that is listed second. Remember, try not to accumulate new debt during this process.
4. Automate your payments. If you can have your credit cards deduct your payments directly from your checking account automatically, this is a great way to eliminate the possibility of human error from the process. Some credit card companies won’t allow you to do this. It would guarantee that your payments would always be on time, and the credit card companies would lose out on possible late fees and finance charges. Even if that is the case, visit your credit cards’ websites and link your checking account. This way you can pay your minimum or more with one click rather than writing a check, finding a stamp, and remembering to drop your payment in the mailbox.
5. Get in the groove. People get into debt for different reasons. Some people like shopping to buy new things. Some people have an addiction. Others are faced with an emergency with no other options that credit card. Occasionally, people make bad choices. Whatever the reason, see what you can do about changing your behavior. Creditors make it easy to stay in debt, and it’s difficult to see the consequences of debt accumulation. If you’re tracking your money, you have a good indication of the effect debt has on your net worth, and you’re able to predict the state of your finances in the future.
The more you’d like to do with your life down the road, the more money you’ll need. Debt, in all forms, works against you. Get in the habit of making good decisions about your money and spending less than you earn.
6. Complete your payoff. Getting out of debt fully calls for a celebration. It may take decades to do so, especially if you have a mortgage. Celebrate however you may like, but don’t fall back into debt.
Updated January 12, 2012 and originally published November 21, 2008.