Along with creating a passive income stream that allows you to sit on a beach and make $10,000 everytime you blink your eyes, getting out of debt is the main financial goal for just about everyone in the modern world.
That’s why “How to get out of debt” produced 769 million results in my most recent Google search and “How to improve my credit score” only revealed 24 million. Yes, we want to improve our credit score because we know that it opens up opportunities like being offered a better interest rate, but getting out of debt affects far more than your interest rate. It’s a true life-changer. A debt free life can be designed and molded. It allows freedom and creativity, while a life burdened with neverending payments and balances must be focused on one goal…making enough money to keep up with your payments.
I know. I’ve been there. I wanted to travel more than anything as a 20-something single man. However, I had been irresponsible with my money and undisciplined in my desire for what that money could buy, so I ended up with more than $40,000 in non-mortgage debt.
I wanted to travel. I wanted to start a small business. I wanted to experience new things. But, I couldn’t because I had a modest paycheck to paycheck lifestyle that wasn’t going away any time soon.
Even without an abundance of income, a debt free life allows your brain to explore the possiblities. When all you have to consider is how to obtain the basic essentials of life, you can design your lifestyle according to your goals. Will you continue to make a fat income and live high on the hog or will you live frugally in order to become less dependent on a paycheck? It’s up to you.
Making a Specific Plan to Get Out of Debt Quickly
You already know how to get out of debt – spend less than you make and apply the extra money on your debt balance. It’s that simple. But, if you’re anything like me, you want a specific gameplan. You want a goal to help motivate you. We all know that a good goal helps to speed up the process and better ensure victory. So, that’s what we’re going to tackle today.
Meet Lars and Laurel Luxury
Lars and Laurel are in debt and they’re sick of it. Their last name has proved to be prophetic for more than a decade as they lived the “good” life, but they’ve recently decided to make a change by reading the entertaining and insightful articles at Simple Family Finance. (Sorry for the shameless plug)
Here’s a rundown of their current situation:
Student Loans: $22,000 balance at 5.0% interest with a $233 monthly payment
Car Loan: $10,000 balance at 6.0% interest with a $235 monthly payment
Credit Cards: $18,000 balance at 18.0% interest with a $540 minimum payment (3% of balance)
Total: A $50,000 balance and a $1,008 minimum monthly payment
Follow along as we take a closer look at Lars and Laurel’s financial situation.
The Snowball Method of paying off debt
I’m sure you’ve already heard of the “snowball method” made famous by Dave Ramsey. The idea is that you attack one specific debt, while making the minimum payments on the others, until that debt is paid off. Next, you would take the money you were using to pay off the first debt and add it to a second debt’s payment until that, too, is paid in full. This pattern would continue until you are debt free.
If I have 3 loans that each require me to pay $300 per month, and I have $100 extra dollars that I would like to use to pay off debt each month, the snowball method would look like this.
1. Pay $400 per month ($300 1st loan payment + $100 extra) on the 1st loan until it’s paid off. Pay the minimum $300/mo. on the other two.
2. Pay $700 per month ($300 2nd loan payment + $300 1st loan payment + $100 extra) on the 2nd loan until it’s paid off. Pay the minimum on 3rd loan.
3. Pay the full $1000 per month ($300 3rd loan + $300 2nd loan + $300 1st loan + $100 extra) on the last loan until it’s paid off and you’re officially debt free.
Dave Ramsey and his followers believe that you should pay off the debt with the smallest balance first in order to achieve small victories along the way and motivate yourself to keep going. Other experts believe that paying the debt with the highest interest rate is the only way to go (and technically they’re right from a purely financial point of view).
Which one should you choose? That’s completely up to you. One is psychological and one is financial, but they both are completely valid. The key is continuing to roll over the extra money to new debts. That’s the important part.
Lars and Laurel have chosen to use the snowball method while paying off the debt with the highest interest rate first.
How quickly do you want to get out of debt?
Here’s where you need to come up with a goal. How many years/months until you want to become debt-free? Be reasonable, but push yourself a little. If you have $150,000 in debt and a $50,000 income, making a goal to get out of debt within the next 12 months is a waste of your time. It ain’t happening without your rich Uncle George kickin’ the bucket, and I don’t think Uncle George would be too happy if he knew you were making such lofty plans on his behalf.
The first step is to take a close look at your current debt schedule. Click on the link for a snowball debt calculator that can help you determine the precise date that you would become debt free by making your scheduled payments as they stand right now. Be thorough when listing your debts, interest rates, etc. If you don’t know this information – find out. It’s important stuff. Fill the calculator in with the minimum payments first to get a current payoff date. (See the tutorial for specifics)
Calculating your personal Debt Free date
Once you find out your current debt free date, it’s time to make a new goal. How quickly would you like to get out of debt? If paying the minimum payments will take you 10 years, but you’d like to be free within 5 years, it’s time to find out what it will take to make your dream come true.
The snowball calculator allows you to enter the dollar amount you would like to use to pay down your debt each month. If your minimum payments require you to spend $800 each month, try entering an additional $200/month (or $1000 total) into the calculator to see what your new debt-free date would be. Through a little trial and error, you can find out what it’ll take to cut your original 10 year schedule in half.
Here’s a brief tutorial on how to use the Snowball Calculator. Skip ahead to the 2:15 mark if you just want to see the calculator in action.
Back to Lars and Laurel Luxury…
According to the calculator, it will take them about 5 years applying the minimum $1008 per month and using the snowball method. However, they’ve decided that they would like to be debt free by January 1, 2016 (about 3 1/2 years instead). After a little trial and error, they’ve noticed that it would take an additional $350/month in order to achieve their goal.
By the way…if they don’t use the snowball method and, instead, just make the minimum payments until a debt is paid off, then spend the extra money that had been going toward that payment on fun stuff instead of debt, it will take 4 years to pay off the car, 10 years to pay off the student loan, and nearly 30 years to pay off the credit card! You can see why committing a constant dollar amount to debt repayment is key. If you can afford to do so, keep rolling over that extra money to create the biggest snowball you can muster.
The Last Step
It’s time for Lars and Laurel to find an extra $350/month. They have two choices – make more money or spend less money. We’re going to focus on the “spend less money” option.
So, next week we’ll discuss my “Find the Fat Method” – a specific, no-nonsense approach to locate extra money in your budget. This is for anyone who wants to get serious about speeding up their debt repayment in order to be free from those pesky loan payments for good.
To be continued…
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