Setting Budgets for Debt Reduction
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Information Gathering
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Debt reduction, short of bankruptcy, involves making regular payments to creditors. The way to know how much money can be devoted to paying down debts is through budgeting. Budgeting is important for any individual, family or business, but it is absolutely essential for debt reduction. The process begins with information gathering, including not just a list of all outstanding debts, liabilities and income, but also the interest rate on debts and the names of creditors. Make three columns, one each for debts, liabilities and income. It will be helpful to have all the receipts and pay stubs for at least the prior month and your checkbook when making these entries. It might also help to use a computer to make a pie chart of your income, showing how it was divided and spent over the previous month. Be sure that your pie chart only reflects actual actual expenditures and not debts payments that weren't made. If there were debt payments that got skipped over in the prior month, a major goal of budgeting should be to get those onto the pie chart as soon as possible.
Debts and Liabilities
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The goal of budgeting is to determine how much money is left over after liabilities to pay down debts. Debts usually refer to long-term obligations that involve monthly payments and interest, things like a mortgage, car payment or credit cards. The longer debts are ignored, the worse they get because of added interest and late penalties. Liabilities, on the other hand, are financial obligations that aren't necessarily due at the moment of budget creation, but are predictable and reasonably certain to occur. This might include things like insurance premiums, rent or school tuition. Other regular expenses, such as groceries, clothing or haircuts, are also liabilities to the extent they can't be avoided. Many liabilities will be fixed costs that can't be paid down the way debts can. Some, however, will be variable, and many of these can be reduced; for example, going to the movies or on vacation are not fixed costs because they can be reduced or avoided altogether.
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Re-Dividing Income: Trimming the Budget
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The two main approaches to paying down debt are directing more of income to debt by reducing liabilities and restructuring debt. The two strategies work best together. You might have noticed that if you only make the minimum payments on credit cards, the principal never goes down. It's essential to be able to send more than the minimum payment in order to reduce the debt. After listing all debts, liabilities and income for the prior month, determine how much income was left over after liabilities. This should be evident if you made a pie chart. Many people are often surprised when they see exactly where their money goes, but be honest and accurate in reflecting the prior month's expenditures. This will be like the before picture of a dieter, because for the next month expenditures that can be avoided will be struck out, making a trimmer, leaner budget. On the pie chart, the sections for debt payments should grow. This reflects the real-world result of having more income available for debt reduction.
Re-Dividing Income: Restructuring Debt
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The second strategy will make that money go even further by restructuring your debt. For most, this means debt consolidation. On your pie chart, this will mean combining all the sections for debt payments into one single section. It's true that reducing all those various monthly bills into a single payment makes it easier to keep track of the paperwork, but the real benefit of debt consolidation is changing high-interest debt into low-interest debt. Some credit cards can be charging interest rates of up to 30 percent. There's simply no reason to pay that much interest. Some credit cards or debt consolidation services will offer a grace period of about a year during which no interest is due at all. Even if such an offer is not available to you at the moment, lowering your interest rate on debts will ensure that more of your income goes to paying down debts rather than lining the pockets of bankers. Once the information is gathered, the success of the budgeting process will depend on the ability to adhere to the final plan and to continue tracking progress by gathering and updating your information.
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