How to Become Debt Free

There's a ceiling to the amount of money you'll earn in your lifetime. Because of this, managing and eliminating debt becomes a paramount priority, as debt reduces your ability to build wealth through saving money and investing.

What's more, debt prevents you from having financial flexibility, which you'll need when unexpected expenses arise, or else you'll have to rely on debt to bail you out, creating a cycle without a promising future for your finances.

How to Become Debt Free

Identifying Debt

Do I know How Much I Owe?

Not knowing how much you owe is an early sign of potential debt trouble because not only does that entails not knowing how much interest you're paying overall, it also means that you may not be receiving all lender bills and making payments on time.

If you find yourself answering a phone call from a lender whom you can't recall owing to, it may be time to take a step back and figure out the best way to gather all your debt information. A good starting point is your credit history, which normally would include all your debt data.

Do I Pay My Bills Late?

If you have difficulty paying your bills on time, you may have too much debt and need to find a way to consolidate, settle or pay off that liability. Do it as promptly as you can because a late bill payment not only lowers your credit score, it also causes your lenders to increase your annual percentage rate.

Incurring a new debt to pay off an existing liability is a clear sign of financial mismanagement and economic trouble. You know you are in debt trouble if you have to barnstorm the offices and homes of groups as varied as lenders, relatives and friends before paying your monthly bills.

Steps to Becoming Debt Free

Becoming debt free is simple once you adhere to several rules. While it might take some time to become acclimated to the changes, the small adjustments you'll make now will benefit your finances enormously into the future.

1. Say No to New Debt

Before we move any further, do this: Take your credit cards and chop them up. You don't need them. If you have debt already, you need to eliminate it, not add to it. Think of debt as weight, the more you gain the more work you'll have to do to lose it in the future.

Don't think of all the rewards you'll be earning by continuing to use the cards. Chances are if you are carrying a balance monthly, the interest you pay will negate the reward benefits you'll receive.

Once you destroy your credit cards, be sure to change your payment information with Netflix, your gym or whoever else you charge a reoccurring expense with. These payments should always come out of cash whether it's your debit card or checking account.

If you have a good history with your credit card company and a great credit score, contact them to see if they can offer you a better deal on your card. Often, credit card providers are willing to lower interest rates if they are afraid of losing you as a customer.

This move is intended to give you the opportunity to pay down your debts at a lower interest rate. Instead of using the new card to charge more purchases, file it away in a safe or safe deposit box. Furthermore, be sure to keep the account open as you pay off your credit card balances because closed accounts can hurt your credit score.

2. Build An Emergency Account

The next step towards eliminating a reliance on debt is to build an emergency savings account. You need to do this because you don't know what the future holds. A drop in income, a surprise car or medical expense can make it difficult to pay if you're living paycheck to paycheck. When this occurs, you'll naturally go back to using credit cards or personal loans to make ends meet, and it becomes a cycle that traps you financially. This is why saving money should be your first priority.

Saving money is a behavioral discipline that takes practice and accountability. The first step towards saving is to establish a goal you can work towards-ideally aim to save $1,000. This will help negate any unexpected expenses that might come up so you can use cash in lieu of credit.

Once you have a savings goal in mind, you'll want to open up a bank account, where the funds you save are not easily accessible. An online savings account is a great route to take. For one, many online financial institutions don't charge a monthly fee for these accounts, so you won't have to worry about keeping an average daily balance. Two, you don't receive a debit card for these accounts - this prevents you from having easy access to withdraw funds-don't request an ATM card if available with the account.

Lastly, anytime you need money for an emergency expense, you can transfer funds electronically from the online account to your bank account. Depending on when you conduct the transfer, it can take anywhere from one to several business days. If you need the funds sooner you can always do a wire transfer. The fees for these vary by whichever financial institution you do business with.

To build this account, you can do several things. One, on your paydays, you can set up a scheduled transfer from your checking to your online savings account. To illustrate, say you want to save $1,000 in the next six months and your employer pays you bimonthly.

Using this example you'll want to transfer at least $83.33 each time you receive your deposit. Banks and credit unions allow you to set up these transfers for free when you receive payment. In addition, you can tailor amounts and frequency of your transfers so they align with when your employer pays you.

The other way is to have a portion of your payment directly deposited into your online savings account. Most employers allow you to change your direct deposit information, so it's important to check with your company's human resources department if this is the way you want to go.

In either case, it's important to develop accountability as you save. Find a trusted friend or relative you know who's good with money and share with them your savings goals. They can help you stay on track so you achieve your objectives.

3. Snowball Your Debt

Once you reached your emergency savings goal, it's time to turn your attention to paying off your debt as quick as you can. This is where you'll first want to examine your budget and eliminate all unnecessary expenses such as cable, the daily coffee, etc. The goal here is to maximize the amount of money you have available to pay down your debts as quickly as you can.

To compliment this, you might want to consider supplementing your income. You can do this in a bevy of ways from selling stuff you no longer use and/or receiving another stream of income through employment. Even if it means delivering pizzas a few nights a week that is still weekly income you can use to become debt free.

Next, you'll want to employ Dave Ramsey's Debt Snowball Method. This is an excellent way to attack debt because it helps you build momentum as you pay down your bills. Here's how it work:

  • First, you'll want to gather all your debts and put them in ascending order from the lowest to the highest balances owed. Notice I didn't specify anything about interest rates here, the balances of your debt are what's important.
  • Next, you need to budget an allotted amount for all debt payments monthly. From there, you'll pay the minimum balances on all debts aside from the one with the lowest balance. Using the rest of the funds available in your budget, you'll pay off the lowest one off as quick as you can.
  • Once you pay off that lowest balance, you use the same methodology and apply that to the next lower balance, moving your way up the debt ladder.

Over time, you'll find this to be an extremely effective method because it gives you confidence you can do this. It is also a less stressful method because you focus on one bill at a time instead of the totality of the debt.

4. Create A Spending Plan

You can create a spending plan to fix whatever debt problem you have and pay off your loans over time. Draw two columns, one with income items and the other indicating expenses. List all your monthly expenses and compare them with your income, giving you a percentage result – 45% debt-income ratio, for example.

If you think the percentage is satisfactory, start implementing the budget plan and closely monitor your spending. Keep receipts, track all expenses during the month, compare actual results versus planned expenses at month-end, and make the necessary adjustments to reach your goal.

How Do I Maintain a Safe Debt-to-Income Ratio?

Debt-to-income ratio equals your total monthly debt payments divided by your monthly after-tax income. Finance people recommend a debt-to-income ratio of less than 50%, meaning a borrower with a reasonable metric should not spend more than half of his or her income on debt service.

To maintain a safe debt-to-income ratio, reduce your expenses or increase your income. Start with cuts in non-noticeable areas in your budget, such as the third Friday night movie session you hold every month but don't really need. Then move on to more noticeable cuts like reducing the kids' music lesson hours, eating out less frequently, and gradually stop buying those pricey organic foods.

Recap

If you are struggling with debt, consolidation might be an option. However, you should attempt to eliminate debts on your own first. Knowing that you have too much debt is one thing, but taking specific steps to gradually pay off the liabilities is another.

You can tell that you're over-indebted through a pastiche of factors, including maxing out credit cards, borrowing to pay bills and not sleeping over your finances. You can fix your high indebtedness by forging and sticking to a spending plan, making sure it fits with your lifestyle, debt-to-income ratio, and spending habits.