Digging out of debt can be painful—but the payoff is empowering. Just think: All that money spent paying interest on past purchases could be money invested for your future. But it takes a committed and consistent plan to get out of debt and stay out.
"Paying off debt doesn't need to be complicated," says Fidelity vice president Ann Dowd, CFP®. "Like so much else in life, it just takes focus. Why not make this year the year that you right-size your debt burden?"
Here are 5 steps to make this the year you take control of your finances and get out of unhealthy debt for good.
1. Look for lower interest rates.
It's difficult to dig out of debt when interest keeps piling up. To make sure that more of your payments go to paying down the principal, shop around for low-interest balance transfer offers or loans. You may even qualify for 0% interest promotional rates. There's typically a fee to transfer a balance: for example, 3% of the balance transferred. Paying the fee and getting a lower interest rate can sometimes be worth it, if paying down the entire balance is going to take time. Do the math to find out if you'll save money by transferring a balance—or use an online balance transfer calculator.
2. Pay more than the minimum.
Making the minimum payment on credit cards can leave you in debt for years. By paying just the minimum, a credit card balance of $1,000 at a 12% interest rate with a minimum required payment of $35 would take 34 months to pay off. Your total payments would equal about $1,184—which means you'd pay $184 to borrow money for nearly three years.
Bumping the payment up to $50 per month would pay off the balance in 23 months and cost $121 in interest. Paying $100 a month would pay off the debt in 11 months and cost $59 in interest.*
Review your spending
Adding a little bit more to your monthly payment can help you pay off the debt in a fraction of the time. But here's the perennial problem—where can you find this extra money? Let's face it: Stumbling onto a pile of cash doesn't happen very often. Common sources of extra money include:
- Reduced spending
- Pay raise
Finding spots in your monthly spending where you could cut back is the most likely source of extra money. The best way to find them is by examining your spending. Look at your spending history through your bank or cash management account, or track your spending for a period of time. After you see where your money goes, look for areas where you may be able to pare back expenses to free up more money to put toward debt—even just a little bit will help. For example, you may be paying for cable channels you never see, or maybe you don't come close to your cell phone data limit. Maybe you have an expensive truffle-and-champagne habit that runs up your food bill. You don't have to give up all of your luxuries, but nearly everyone has areas where they splurge more than necessary.
3. Have money available for emergencies and unplanned expenses.
Getting out of debt while having nothing saved for the inevitable emergency may leave you running in place. You do all the work to pay down debt and before you know it, the hot water heater springs a leak or your car suddenly needs an expensive repair. Without an easily accessible stash of cash, credit cards may be the only option.
Think of your emergency savings fund as a bill. With rent or mortgage payments, contributing to a retirement fund, and myriad living expenses, you already have a lot to balance. But if you turn saving for an emergency fund into a monthly priority, you'll get in the habit of contributing to it regularly. Continue to save until you've accumulated between 3 and 6 months' worth of expenses.
Work to keep your essential expenses under 50% of your take-home pay, and be sure to save for the future too—contribute at least enough money to your workplace retirement account to get the entire match from your employer. Money that's left over after you've met all your necessary obligations, built up your emergency savings, and obtained your entire employer match can be funneled into debt repayment, if you still have any left, or used to boost your retirement savings. Once you are out of debt, aim to ramp up your retirement saving to 15% of your annual income before taxes—including the employer match.
4. Hide your card.
It's nearly impossible to get out of debt if new purchases keep adding to the balance. Consider hiding your credit cards so you can't keep charging. That can be a little bit easier said than done when shopping on the internet. Some online retailers offer the option of saving your payment information. Decline the option if you have the chance—making it a little more difficult to spend money is often all it takes to skip unnecessary purchases.
Knowing how much debt you have and how much it costs may help you stop charging. Make a list of your debts, the total amount owed on each, the monthly payment, and the interest rate each lender is charging you to borrow.
Attack your debts one by one. If you have several loans and credit cards, focus on the debt with the highest interest rate first. Continue to make the minimum or scheduled payments on other credit cards and loans. Once you've paid off the highest interest debt, start paying as much as possible to the next highest interest rate debt.
5. Learn to use credit wisely.
Following a few basic rules for credit can help you learn to use it wisely. Avoid charging more than you can pay off in one month and always make your payments on time. If you do find yourself with a balance that follows you from month to month, make it a priority to pay it off so that you can use your money to achieve your financial goals—especially your retirement savings goals.
Now, ramp up your savings.
After you've paid off debts, try to avoid slipping back into the spending habits that may have led to the problems in the first place. Keep cultivating good habits by saving for the future. Make sure your emergency fund is fully stocked. Take the time to get your retirement savings on track. Now that you're not paying credit card companies every month, you may have some extra money to set aside for the long term.
TAKE THE NEXT STEP
If you've paid off your debt and kept up the good habits, here are some additional tips for staying financially prepared.