The Balanced Spreadsheet-Financial News, Budget Advice, Debt help, Financial Tips, and other advice

January 16, 2010

The Financial How to series Part II. How to get out of debt

Today we are going to continue in our “Financial How to . . . . .” series. The goal of this series is to give practical insight on how to get one’s finances in order for 2010. In part I we discussed how to set up a budget and today in part II we will discuss how to get out of debt.

What kind of Debt are we talking about?

I simply divide debt into two types; mortgage debt and non-mortgage debt. When talking about getting out of debt I am talking about non-mortgage debt. While ultimately your goal is to become 100% debt free, I am focusing on becoming non-mortgage debt free because that is something that usually can be done in a short time frame between 6 months to a couple of years. Mortgages, however, are usually one’s biggest debt and take usually 7+ years to fully pay off.

That leaves us today with every other kind of debt imaginable from credit cards, car loans, and student loans to IRS and family loans. Second mortgages can be a little tricky though. Typically if the balance is greater then half your income, I would just treat the debt like a first mortgage and put it on the back burner. If it is less then half I would then treat it like any other debt.

Listing your debts

Now that we have established what debts we are talking about it is now time to start the debt reduction process! First thing you will want to do is list your debts from smallest to largest. Next, after doing your budget you should know how much “extra” money you will have each month, after necessities and fixed expenses, to apply to your debt. Then start making the minimum payment on all of your debts and put the extra money from your budget onto the smallest debt. This is called the “Debt snowball” method. Below is an example that illustrates how this is done. In our scenario the person has $22,400 in debt and four different monthly payments. The minimum payments total $531.25 with $750 of extra money for total monthly reduction of $1,281.25.

Why the lowest amount? Would it be better to pay off the higher interest rate debt first?

From a mathematical stand point the debt snowball is usually the costliest way to go. By paying off the smaller loan first you can sometimes allow greater balance with a higher interest rate to accrue more interest. However I have found that the problem with debt is not the interest rate, but rather with personal behavior and by paying your smallest debt first and knocking it out, you will gain momentum and become more aggressive in paying off your debts then you would if you paid off the higher interest rate but kept more debts outstanding. By changing your personal behaviors you will never go back to debt which will more then make up for the extra interest paid.

After you pay off the first debt

Going back to our example, after three months our student loan would be paid off! After paying off the student loan we would then take the $60.00 minimum payment and apply it to our credit card #1 balance. We would then pay $885 a month on credit card #1 ($75 minimum + $60 student loans +$750 in extra money). After paying that debt you would then apply that payment to credit card #2 and son on. Your debt reduction would approximately look like this:

 

In 19 months you would be debt free!

Exception to the Debt Snowball

There is really only one exception to the debt snowball. That is IRS, State, or local income taxes. Always put them atop of the debt snowball. The reason is simple, the IRS has the ability to garnish wages without actually suing you, and the debt does not go away if you ever have to file for bankruptcy. Couple that with high late fees and interest payments and you will want to get them out of your life as soon as possible.

Conclusion

Getting out of debt is not a piece of cake. It is hard work and a lot of sacrifice but the payoff is well worth it! The debt snowball might seem daunting to you at first, but go ahead and try it, and if it does not work you can always go back into debt. J In our made up scenario 19 months is probably a little conservative. During the 19 months we took to pay off the debt, a variety of positive financial events could have happened such as getting a raise, getting a refund back from the IRS, or tightening your budget even more and coming up with extra payments to make on your debt, which would all decrease your time in debt!

Come back soon for Part III in our “Financial How to . . . . . .” series on how to start and use your emergency fund.

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6 Comments »

  1. […] up over the weekend will be part II in the “Financial how to . . . . .” series on getting out of debt. Possibly related posts: (automatically generated)The Financial How to series Part I. How to start a […]

    Pingback by Follow up to “Financial How to. . . .” series Part I. Updating our own budget « The Balanced Spreadsheet-Financial News, Advice, tips, and more — January 16, 2010 @ 1:00 pm

  2. I am not sure why you write this blog.
    Si stumbled across it a few days ago and have various reasons for being interested….but would like to know if this blog is a commercial venture….

    Comment by steve — January 18, 2010 @ 4:43 pm

    • Hey Steve, thanks for being a reader. I started the blog this past June just as a way to write about something that I have a passion for and as a way to give out financial advice as well as to keep an account of my own personal finance journey. I do not do this for any commercial venture as I make no money off of it; it is just more of a hobby. One of my Financial Goals is to become a financial counselor/coach. But we are along way from that. 🙂

      Thanks again for being a reader and feel free to post coments whenever.

      Comment by thebalancedspreadsheet — January 18, 2010 @ 6:34 pm

  3. […] those looking to shave some money off of your monthly budget and getting some extra cash flow for debt payments.  We personally have Verizon so we might be taking advantage of the price wars soon.  I love it […]

    Pingback by Price Wars over Cell Phone Service heating up « The Balanced Spreadsheet-Financial News, Advice, tips, and more — January 20, 2010 @ 3:07 pm

  4. […] American today, how to avoid impulse buys.  The biggest threat today to keeping a budget and staying out of debt is the impulse buy.  Whether it is something big like buying a new car, to spending $50 a week at […]

    Pingback by How to avoid Impulse Buys « The Balanced Spreadsheet-Financial News, Advice, tips, and more — January 31, 2010 @ 12:20 pm


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