Start Living a Debt Free Life

If you feel like you are drowning in debt, you are not alone. In 2014, the average American household had $15,000 in credit card debt, and nearly $40,000 in mortgage debt. In addition, 35% of Americans are delinquent on some form of debt. If you are concerned about your own debt load, it is possible to reduce it by aggressively paying down debt through budgeting, lifestyle changes, and using financial techniques to lower your interest rates.

Steps

Understanding Different Types of Debt

1. Distinguish between secured and unsecured debt. Individuals often have a tendency to lump all debt together, when in reality debt differs significantly in cost, value, and risk. Knowing these differences helps you recognize which debt to tackle first. The difference between secured, and unsecured debt is the first distinction to understand.
   • Secured debt, also known as "asset-backed debt", refers to debt that requires some sort of collateral to obtain the loan. These loans are seen as lower risk by a lender, since if you default on your loan, the lender can require the collateral to be sold to pay off the amount owing. It is for this reason that secured debt often has lower interest rates than other forms of debt.
   • Examples of secured debt include: Home mortgages, home equity lines of credit, auto loans, or credit cards with a secure line of credit.
   • Unsecured debt refers to receiving a loan with no collateral. These typically have higher interest rates, and include credit cards, lines of credit, student loans, or payday loans. These types of debt are often more costly.
   • Generally speaking, secured debt is preferable to unsecured debt since it is backed up by an asset like a home or a car. Debt repayment should prioritize eliminating unsecured debt this debt is more costly, cannot be quickly repaid in the event of a crisis by selling an asset, and does not contribute to owning a potentially wealth-building asset (like a home).
2. Learn the cost differences between types of debt. Unsecured debts are generally higher interest than secured debts, but there are cost differences within each category of debt to be aware of. Understanding which debt is most expensive helps target which to focus on paying.
   • Credit card debt: This is commonly the most expensive form of debt. Average rates are 15% for fixed-rate debt and 17% for variable rate debt, although costs can be much higher depending on credit rating and history. Unsecured credit cards generally have higher interest than secured cards.
   • Personal loans: These are typically the next most costly but rates vary dramatically depending on credit rating. A personal loan simply refers to any amount that can be borrowed for almost any purpose from starting a business, to funding a vacation, to paying off other types of debt. Rates for these types of loans typically vary between 5 and 11%. Personal loans are typically unsecured debt.
   • Student loans: Student loans typically vary between 4 and 8% (although private loans can be more costly). Federal loans are typically cheaper. Despite being relatively cheap, unsecured debt federal student loans have strict rules of repayment. Private loans are in part more expensive to cover the increased risk to the lender, since they are unsecured debt.
   • Mortgages: Mortgages are typically one of the least costly forms of debt, and they have the added benefit of being a secured debt backed by a significant asset that (hopefully) increases in value over time. Mortgage interest rates vary tremendously based on credit score, whether the mortgage is fixed or variable, but typically rates are between 3 and 5%.
   • Auto loans: Auto loans vary in cost dramatically and can be exceptionally high. While the average is between 4 and 6% for a fixed rate loan, purchasing from a "buy here/pay here" dealer can lead to rates well into the double digits. Although auto loans are secured, the vehicle used as collateral is a depreciating asset and the increased risk to the lender results in higher interest rates.
   • Payday Loans: These are short-term loans that are mean to be repaid by part of a future paycheck. If you want to borrow $100, the lender will give you that amount, minus a fee (or with a fee tacked on to the amount you must repay). You are then expected to repay the amount from your next payday, otherwise you incur further (and possibly) fees as the loan "rolls over." Interest rates can be in excess of 50% and even up to several hundred percent. These are extremely expensive loans and should be avoided if possible.
   • While there are other types of debt, the important thing is to be aware of the interest rates, balance, and secured or unsecured nature of each loan you have.
3. Recognize that not all debt is to be valued equally. Some financial advisers like to differentiate between "good debt" or "better debt," and "bad debt".. Knowing the distinction between the two types is important, as it allows you to focus your resources on eliminating, and living without bad debt.
   • Good or better debt refers to any debt that creates value, or debts that produce more wealth over the long-term. Mortgages, school loans, business loans, or real estate loans can be seen as good debt. In each case, these loans are investments, and can (ideally) generate more wealth for you over time. These forms of debt can be approached with less caution, but still can cause issues if they don't generate the expected wealth. They are typically lower cost, and secured (with the exception of student loans).
   • Bad debt refers to any debt that does not create value over time. For example, this could include any debt that is used to purchase disposable items, or items that deteriorate in value quickly over time. Examples of bad debt include, credit cards, store cards, auto loans, or payday loans. Bad debt involves money spent for consumption, rather than investment.

Changing Your Spending Methods

1. Stop using credit cards. Credit cards are one of the worst types of debt, because of their high rate of interest. To avoid the temptation to use them, make them unavailable. If the temptation to use them is too much, cut them up. If not, take them off your person and put them away.
   • Some people literally put the card on ice by freezing it in a block of ice in their freezer. This decreases the likelihood of impulse spending.
   • With the advent of online shopping, it is also important to consider what cards you use online. Often, if you have purchased from an online site in the past, your card information will be saved. Review sites you frequent and check that your credit card information is not saved there. If it is, replace it with a debit card. Remember - If you can't afford it today, you can't afford it tomorrow.
   • Note that closing credit cards can adversely affect your credit score. One aspect of your credit score is known as "credit utilization," and this simply refers to how much of your total available credit you use. The less you use, the better. By closing a card, you reduce your total available credit, thereby making your total usage higher.
   • In some situations it can still be beneficial to close the card. If you have consistently maxed out your limit or otherwise had a poor relationship with credit cards, it may be worth taking the hit to your credit score and closing out some cards.
2. Start using cash. Using cash is psychologically more painful than paying with a card. Sticking to cash will encourage you to spend less and save more. It is also easier to keep track of your spending with cash. Once you have allotted yourself a certain amount of money per month for discretionary living expenses, consider taking this amount out in cash and exclusively using it for daily expenses. If you follow this course, you will not accidentally go over budget.
   • There are some items which can be difficult to purchase with cash: airline tickets or train tickets, for instance. Consider whether you are likely to incur such expenses during the course of the month and, if so, leave additional money in your account to cover them.
3. Stop paying with checks. Checks have become rare in recent years and for good reason. It often takes a long time to process a check. The recipient of a check might not cash it for weeks after you give it to him or her. It can be difficult to keep track of your budget if there have outstanding checks that have not been cashed. In a worst case scenario, you might forget about a check and, when it is deposited, have insufficient funds in your account. As a result, you will be hit with a fee.
   • By contrast, you can set your debit card to halt payments if there are insufficient funds in your account, saving you fees. Bills paid with debit cards process almost instantly, helping you keep track of your balance.
   • If not using checks is impractical for you, consider using a money order. Unlike checks, a money order cannot bounce.

Lowering the Cost of Your Debt

1. Request a lower interest rate from your creditors. Simply calling each creditor and asking for a reduction in rates can be tremendously effective. In fact, one survey found that when 50 credit card customers asked to have rates reduced, 56% were successful.
   • Call each provider, and state that you have been having difficulty making payments at the current rate, and that unless you can obtain a lower rate, you will likely need to switch companies as you have received better offers. Lenders are eager to keep customers, and are often willing to reduce rates to do so.
2. Consider a balance transfer credit card. A balance transfer card can be an effective way to reduce rates. A balance transfer card refers to cards that typically charge a 0% or near 0% rate to borrowers who transfer their balance from another credit card.
   • By utilizing this option, you can effectively reduce your interest rate, and have all your payments be applied directly to the principle balance, which allows your debt to be reduced faster.
   • Ensure you are aware of the terms of the card. Typically, after 12-24 months, the interest rate on the card will rise up to the standard level, so it is important to ensure you take advantage of the low interest rate period.
3. Consider a debt consolidation loan. If you have good credit, go to a bank or credit union and ask about a debt consolidation loan. Debt consolidation loans refer to taking out an additional, lower interest rate loan (like a line of credit), and transferring higher interest rate debts to that particular loan
   • This is especially useful if the majority of your debt is credit card debt. Transferring your debt to a line of credit can effectively reduce your rate. Be aware, however, that while rates are lower, terms are often longer. This means that while your monthly payments may be lower, you may actually pay more interest over time due to the longer term.
   • Whenever refinancing debt, whether with a personal loan or a balance transfer, pay close attention to the details of the new loan. Be wary of online lenders – these are often scams. When taking out a personal loan, verify that the terms clearly state “no prepayment penalty.” If not, you might find yourself facing fees if you pay off your loan early.
   • Only pursue this strategy if you are certain you have the discipline to not run up debt on your newly paid of credit card. Otherwise, this strategy can actually increase debt.
4. Use your savings to pay down debt. This is a risky strategy that makes financial sense, but is normally counseled against because it exposes you to personal risk. The average rate of interest in a savings account is only .06% while that of a credit card is 15.07%. That means your money will earn much more paying down a credit card than in a savings account.
   • Be aware of the risks associated with this strategy. By applying your savings to a debt, you may reduce your debt, but you may be ridding yourself of an important safety net.
   • Only apply savings to your loans that are above what is necessary to afford your basic living expenses for a 3 month period. If you require $4000 to live for 3 months, and have $10,000 saved, consider only spending $6,000 on debt.
   • You should also only do this if you are fully committed to quickly paying off all your debt and rebuilding your savings.

Budgeting Your Money

1. Collect your financial information. The first step to budgeting is to gain an accurate assessment of how much you earn and spend every month. Find all of your monthly bills and payment stubs. This includes your paycheck, your rent bill, your utilities (cable, electricity, water, heat), and your monthly loan obligations. Included in loan payments are credit card bills, mortgages, student loan bills, and car notes.
2. Create a spreadsheet. Using a spreadsheet can be a quick and easy way to tally your monthly income, expenses, and determine how much you have left over (or what expenses you can reduce), to create funding for debt repayment.
   • On excel or a piece a paper, create one column listing your monthly earnings, with a sum at the bottom. Make sure to subtract taxes and other automatic deductions, like insurance and retirement savings from your earnings to get an accurate assessment of what you earn every month.
   • Create a column next to that to add up all of your fixed monthly expenses: bills that you cannot avoid paying. This includes housing, utilities, and minimum monthly credit payments.
   • Alternatively consider using software like Mint, Quicken, Microsoft Money, AceMoney or BudgetPlus to calculate your budget. Some of the previously mentioned programs are free. They have useful additional features that a simple spreadsheet does not. They can track your credit score, warn you about bills, and isolate unnecessary expenses.
3. Determine how much money you have after fixed expenses. Subtract your fixed monthly expenses column from your revenue column. The resulting number is the amount that you can afford to allocate towards accelerating your debt repayments.
4. Set a goal to pay down a loan. Set a goal of paying off one loan in six months, a year, or two years. Divide the balance of that loan by the number of months that you would like to pay it off in. That will be approximately how much you will need to pay per month, in addition to minimum payments, toward paying off your debt.
   • Depending upon the type of loan, paying the minimum monthly payment might not be enough to become debt free in a reasonable time period. Even if it is, the longer you wait to pay your debt down, the more you will have to pay in interest. Whenever possible you will want to pay off your loans quicker than you are required to.
5. Create a spending budget based on your debt repayment goal. For example, assume you determine that you need to pay $200 per month to pay down your loan on your schedule. You can use that amount to organize your spending in other areas.
   • Look back at how much leftover money you have after subtracting your fixed expenses from your pay. Simply subtract from that amount the amount that you are setting aside for debt payment. The remainder is the amount that can be spent for things like food, entertainment, transportation, etc.
   • For example, if you have $500 left over after fixed expenses, subtracting $200 for debt repayment would leave you with $300 for your remaining expenses.
   • If you find the remaining amount is insufficient, you may need to reduce your debt amount, or consider the options for reducing expenses in the following parts.

Living on Your Budget

1. Cut unnecessary expenses. You will need to adjust to living off the smaller budget that you have set and, whenever possible, even less than that. This means cutting out unnecessary daily spending: fewer lattés at the café, more homemade coffee; fewer lunches out, more bagged lunches from home.
   • Do not forget to look into your fixed expenses category to reduce costs as well. For example, can you consider moving into more affordable housing? Is taking a bus instead of driving an option? Can you get rid of cable or cut out premium channels?
2. Combine errands. This will save money on gas. Go to the gas station, post office, and grocery store in a single trip. Try to do as much as possible on the commute to and from work. When possible, walk.
3. Watch for deals at the grocery store. Food and basic household expenses can constitute a large percentage of your budget. By being conscious of price here, you can save a lot of money in ways that might not significantly affect your standard of living. Cut coupons. Look for cheaper alternatives of what you normally buy.
   • When comparing prices at the grocery store, consider using your phone to keep track of the cost of items you typically buy. This will give you a better sense for which store you should shop at.
   • Consider grabbing a basket, as opposed to a shopping cart. The larger shopping cart will encourage you to buy more than you need.
4. Sell items you do not use. With the advent of e-commerce sites like eBay, it has become easy to turn a profit on gifts you never wanted or old purchases you have grown tired of. Study the website to see what prices similar items are selling for. Then, take some time to think of a headline for your antique dresser that highlights its unique features and catches the buyer's attention.
5. Relax. Focus on the progress, not the sacrifice, you are making. Every time you hit a milestone, like paying off a card, celebrate.
   • Consider creating a visual display to track debt payoff, like a large poster or image representing a big goal.

Addressing your Bad Debt First

1. Pay down the loan with the highest rate of interest. One of your loans will have a higher rate of interest than the others. You should pay the minimum balance on all your loans, except for this one. Invest all of the money you have saved for paying down your loans to attacking the loan with the highest rate of interest. Paying it down first will cut your monthly interest obligations and allow you to pay down your principal more quickly.
   • If you have managed to save more for the month than you planned, invest it in paying down the highest interest loan. Do the same if you earned more than expected because, for example, you sold a household item or earned a bonus at work.
   • Some experts recommend paying off the smallest loan first, rather than the loan with the highest interest. This fosters a sense of progress and encourages you in your debt repayment effort. Behaviorally, this actually can result in paying off debt more quickly. Some studies find that this method is more effective. However, you will pay more in interest and extend the length of your repayment as long as the highest interest loan is outstanding.
2. Reinvest your savings. As you pay off your cards, your monthly interest charges will decrease. It might be tempting to loosen your belt and expand your discretionary spending. Instead, you should look at it as an opportunity to pay off your debt quicker. If you keep to the amount you initially allotted for debt repayment, you will pay off your debt faster each month.
3. Stick to good debt. If you are forced to take out any loans, take out loans on items that accrue value. Mortgages and student loans are considered the best type of debt, because homes typically retain or even increase value, and your labor will become more valuable after receiving an education. Credit card debt on the other hand is bad. Car loans are also bad debt, because a car will depreciate rapidly, meaning that the value of the car will quickly be less than that of the loan. Spend as little as possible on a car.

Paying Down Your Student Loans

1. Do not take out student loans if college will not significantly increase your earning power. As a rule of thumb, you should not take out so much in student loans that you will pay more than 10% of your monthly income post-graduation. Research the average salaries of the field that you would like to enter and divide by twelve to estimate your monthly earnings. Do not take out a loan that would require you to pay more than that per month.
   • Student loans are typically considered a “good” form of debt, because college should increase your earning power enough to pay back the loans. Just be careful that your career choices are compatible with the amount of debt you might incur.
   • Be cautious when taking out loans to attend a for profit university. Tuition at these institutions is very high and their graduates have had difficulty obtaining jobs. One major chain of for-profit universities is currently being sued for its practices.
   • Do not let student loans deter you from pursuing a degree in highly profitable fields like medicine. Tuition can be particularly high in fields that require postgraduate degrees, but the earnings are more than sufficient to cover student loans. When in doubt, closely and intensely study statistics for your profession of choice. If you are entering a postgraduate program, it should also be able to give you statistics on student placement. Ask for these to confirm that the program is competitive and that it will secure you a job commensurate with the average wages in the field.
2. Seek student loan forgiveness. If you meet certain requirements for long enough, the remainder of your debt will be forgotten. Specific types of student loans, including Direct Loans, Federal Family Education Loans, and Federal Perkins Loans can be forgiven if you make 120 on-time payments while working for a public service organization. Such organizations include the federal, state, or local government and not-for-profits designated as tax exempt by the IRS.
   • Find an Employment Certification Form on the federal student aid website. Submit it annually to verify that you are meeting requirements for loan forgiveness.
3. Ask an employer to pay off your student loans. Employers are often willing to commit some money to paying off student loans in fields that require specialized skills, including tech, nursing, engineering or finance. You should raise the question when you and your employer are scheduled to discuss compensation. An example would be during hiring negotiations. If you are already working for a company, wait for your annual review.
   • Expect to forego a higher wage and commit to work for the company for a set years of time in return for the student loan payment. This can be a mutually beneficial arrangement because it will save your employer money in wages over the long term, while shaving off interest on your loans.
4. Claim your tax deduction. You can save money by claiming a tax deduction on interest paid for student loans. You cannot claim a deduction for the principal on your student loan. Call your lender to ask what portion of your payment was toward the interest on the loan and what was on the principal.
   • You can only claim this deduction if your modified adjusted gross income as an individual was less than $75,000 or $150,000 as a couple. The deduction also only applies if the loan was taken out for educational expenses. Consult an accountant to verify that you qualify.
5. Pay off private student loans first. This is an exception to the general rule that you should pay off high interest loans first. Private loans offered by banks are often “variable” loans, which means the rate of interest changes with the general circumstances of the economy. Right now, the interest you pay on these might be lower than what you pay on your federal loans. However, as the economy improves, these rates are likely to go up. Save yourself the risk of rapidly growing credit bills by putting whatever extra money you allocate to student loan repayment toward paying off your private loans.

Tips

• Be strict with yourself.
• Not all debt is created equal. Avoid payday loans and credit cards. These have high rates of interest. Student loan debt and home mortgages are less problematic.
• Do not be so afraid of debt that it prevents you from purchasing a home or seeking an education. However, even when pursuing these objectives, pay special care to verify that you have the resources to pay off whatever loans you take out.
• Remember, paying the minimum balance on your credit card is never a good deal.
• If you think you "need" something, wait one a month before you buy it. If you still believe you need it, then get it.

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Sources and Citations

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• Start Living Frugally