Debt Elimination and Debt Reduction Strategies
Written by: Kristy Welsh
Last Updated: July 14, 2017
Have you taken on more debt than you can handle? You're not alone. Thousands of Americans are in the same boat, with many of them defaulting on loans, losing their homes and cars, and some even filing for bankruptcy. It doesn't matter how much money you make, if you can't live within your means, you will become a slave to your creditors.
This article is by no means a comprehensive treatise on financial planning, but rather a list of strategies you can use to start eliminating and reducing your debt.
Why Are You in Debt?
Money is a powerful force that can destroy you if you let it. You have to learn to control your money instead of letting it control you. If you don't, you'll never get out of debt and will continue to dig a deeper hole.
Be brutally honest with yourself and really examine the reasons why you are in debt. We are not referring to financial conditions which may be beyond your control, but about the times when you let the lure of shiny new toys control you. Ask yourself the following questions - and be honest in your response!
- Do you buy stuff to mask your own insecurities?
- Are you using money and buying things as a way to comfort yourself?
- Do you feel you have to compete financially with your friends, neighbors, or family members?
- Are you trying to impress someone?
- What is it that compels you to buy something right now?
- Why do you lack self-control to buy it later or may never?
These are serious questions which must be answered before you attempt to reduce your debt with any kind of budget or financial system. Otherwise, it's like treating cancer with a Band-Aid. You might even consider psychological counseling for your money difficulties.
How Much Debt Do You Have?
It is important you be fully aware of how much debt you actually have no matter how painful it is to closely scrutinize this aspect of your finances. Take a sheet of paper, write down the amounts of all your debts and total them. Keep this total amount fixed in your mind. It's been said that pain and pleasure are powerful motivators. If the image and/or idea of all that debt is causing you enough pain, the theory is that you will take aggressive measures to change your behavior and start on the elimination path.
How to Reduce Your Debt
Put Away Your Credit Cards
Put away your credit cards and make a commitment not use them. If you don't think you can kept the pact you've just made with yourself, give them to a friend or relative to hold. Or better yet, cut them up. The thing you don't want to do is cancel or close your accounts. Closing accounts that are old (60 months or older) are valuable to your credit score and can have a negative impact on your credit score if you close them.
Make Payments on High Interest Loans and High Interest Credit Cards First
Paying off the small debt may offer greater relief, it is not necessarily the best approach to minimizing your debt burden. If you have some extra money at the end of the month, put that extra money on the loan with the highest interest rate. By making a dent on the principle owed, it will lower the amount of interest you will pay on that money which will in turn save you money in the long run.
According to a study done by a consumer behaviorist at the Olin Business School at Washington University in St. Louis, people really like closing accounts. That is, they will close a small debt account that has a low interest rate at the expense of paying down a larger loan with a higher interest rate. Throughout a series of debt-management experiments, the researchers found that participants consistently paid off small debts first, even though the larger debts had higher interest rates. In fact, no participant in their study used their cash to pay off the loan with the highest interest rate.
Bottom line, paying off your highest interest rate credit card first will shave months off your debt. With your other debts, continue paying just the minimum. After you finish paying off your highest interest rate card, move on to the next highest interest rate card. Roll over the amount you paid each month from your first card to pay off this one. Don't be tempted to use the money elsewhere - stay disciplined. You’ll pay off the second card even more quickly. Continue this strategy until all your debts are paid.
Contact Your Credit Card Company
If you find yourself unable to pay your bills on time, communicate with your creditors. Be honest with them and explain your financial situation. Ask them to reduce your payments or the interest rate. Tell them you plan to pay off the debt. The worst thing you can do is not communicate. They may assume you are unwilling to pay your bills and get nasty.
Transfer Balance to a Lower Interest Card
If you can, try to obtain a lower interest credit card and then transfer the balance of the high interest card to that one. Make sure to read the fine print when making this transfer. Sometimes the wording of these low interest cards sounds good at first until you really dig down to the nitty gritty and read the fine print of the contract.
Sometimes these low to zero interest credit cards are only available to those with good to excellent credit. If you have not been late on your payments and think your credit may be pretty good, give it a shot. Also, some offer introductory rates of 0% and then jack it up to 12% after the honeymoon period, make sure you stay away from those types of cards. Try to stick with a card that starts off with a low interest rate that does not increase.
Borrow Against a Life Insurance Policy
One way to get out from under this enormous amount of credit card debt is to find some other sources of money from which you can borrow or withdraw. A great source may be a life insurance policy with cash value you can borrow against. We know, you are still borrowing money to pay off borrowed money, but the interest rate on the life insurance policy will be far lower than what you are paying the credit card company. Pay off the card with the highest interest rate and then you can make payments back to the life policy.
Negotiate a Better Interest Rate with Your Creditor
If you cannot get a lower rate card and you do not have any other means to get some additional funds, try negotiating a better interest rate with the credit card company. Let them know about your situation and tell them that if they do not work out some new terms with you, you may have no choice but to file for Chapter 7 bankruptcy. More often than not, a creditor would rather work out a deal with their customer than to completely lose the entire account.
Roll Your Debts into a Second Mortgage
If you own your home, you might consider a debt consolidation loan. This kind of loan is a second mortgage on your property which allows you to consolidate your debts into one payment. Some loan programs require no equity or appraisal. You can use this loan to consolidate credit card bills, car payments, or any other bills. Interest on this loan may be fully tax deductible depending upon your situation. Consult your tax advisor. As with any home loan, this is a lien on your property. If you sell your home, you must pay off both your first and second mortgages. In addition, although you may be making lower monthly payments, you may be paying for a longer time period than if you paid off each individual debt.
Consider Consumer Credit Counseling
Make an appointment to see a credit counselor. You should be able to find a free service in your area that will help negotiate payments with your creditors, and give you good financial advice. You can find one on this site: NFCC.org. They'll give you a fresh perspective on your financial burden, and help you realize you're not the only one dealing with debt. They'll also be candid with you and tell you whether or not you should consider bankruptcy as an option.
How to Live Debt Free
Now that you've reviewed some of the personal reasons you've found yourself in debt, and taken some drastic measures to attack your debt, it's time to develop a plan to determine where all your money is going, and develop a healthy financial strategy. You must be able to account for every penny you spend each month. Don't worry, you won't have to cut your spending yet. Here's a simple method to develop a plan which may fit your comfort zone.
Take a sheet of paper, and write "Master Budget" at the top. On one side, list all your relatively fixed expenses (mortgage/rent, telephone, electric, water, gas, car, credit card minimums, etc.) Better yet, if you have a smart phone, there are tons applications online you can download to track your expenses and make a budget. A nice thing about using a smart phone is that you always have it with you.
Now comes the tough part. You must estimate how much you spend on various expenses like food, eating out, entertainment, stuff for the house, school, clothing, car repair, gasoline, etc. If you have old receipts, you can use them as a guide for real expenses.
Track all your expenditures for one month. At month's end, total each category, and you'll know exactly how much you spend on everything.
If you're not using a smart phone application, you'll need to carry your budget notebook where you go. Carry this notebook with you wherever you go. Be very detailed on your categories. For example, one category might be "Eating Out." Under this heading, write down the date, description, and the dollar amount for each time you eat out.
No matter how you do it, tracking your expenses allows you to see exactly where all your money is going. If you don't know where your money is going, how can you expect to control it?
After you've totaled your categories, transfer them and their respective expense totals to your Master Budget spreadsheet.
List your take home income after taxes on your Master Budget. You might want to develop different budgets based on your pay periods. Should you pay the phone bill on the first of the month, or would it be better to pay it later in the month? You may find one pay period has a tighter budget than the other because you have to pay the bigger bills like your mortgage, rent, or car payment at the beginning of each month. Some lenders will let you change the payment date - this might be a good way to space out your large payments.
Now the challenge begins. Balance your income and expense categories, so you stay within your budget. Leave yourself a $200 cushion in your account. Take a long hard look at your expenses and see how you can reduce them. Let’s look at the category of "entertainment," which may include dinners out, movies, movie rentals, plays, etc. Let’s say you’re currently spending $75 per weekend on eating out and entertainment. That’s $300 per month. Why not only spend $100 and take $200 to make a larger payment on one of your high-interest credit card bills?
You may be shocked to realize how much you spend on little things. For example, if you spend $2 per day on gourmet coffee, you spend $40 per month just on coffee. Why not buy a nice coffee maker, and make your own, or at least have coffee out only once or twice a week?
You'll have to play around with the amounts you set for your expenses categories. You don't want to completely cut out your fun. Otherwise, you'll give up on your budget completely. Cut back a fair amount, and see how it feels. Adjust as you go and ask yourself these questions:
- Could we sell our home and buy or even rent a smaller place until we get back on our feet financially?
- Should we move to a different area where housing is less expensive?
- Do I really need to buy premium gas?
- Why not wait and rent a movie, instead of paying $10 to $12 to go to the theater?
- Do I really need all those magazine subscriptions?
- Do I really need those movie channels? Could I live without cable TV?
- Do I really use my bottled water service? What are some cheaper alternatives?
- Do I really need a new dress, suit, purse, jewelry this month?
How you answer these questions all depend on how quickly you want to get out of debt.
By now, your Master Budget should list every category where you money goes. When you start living out your new budget on your the next pay period, enter into your spreadsheet (paper or electronic) the individual amount you have allotted for each category at the top of its own page. Think of each category page as a mini-account log. Every dollar you spend must be categorized and deducted from its appropriate category account balance.
If you're recording expenses in a notebook, remember to carry your notebook with you everywhere. If you're doing it on a smart phone, you will probably have your spreadsheet with you at all times.
When you get to zero in one category, you can't spend any more in that area. However, what you'll find is that you have other categories that have money left over at the end of your budget period. You can roll these amounts over to categories you've zeroed out, or better yet, use those extra dollars to hammer away at your debt. Revisit your master budget and adjust it accordingly.
Still looking for ways to make that budget stretch further? We have lots of articles on budgeting and saving money with tips ranging from using coupons to save money to how to start saving for retirement. With all of this vast information at your fingertips, there is no better time than now to eliminate your debts and build up your nest egg.