How to Get Out of Debt

Learn the basics of creating a working budget and applying it to pay off credit card debts.

Difficulty: Moderate

Instructions

Things You'll Need:

• Steady Income
• Basic Math Skills

1. 
   Example single-paycheck budget

   Create a budget that you can work with. Generally, the best way to do this is by using a spreadsheet application like OpenOffice or Microsoft Excel. Since it's possible that you'll make several revisions to the spreadsheet over time, it's best to include at least three columns: Title, Budget Amount, Running Balance.
   
   As you'll notice in the basic example here, we are tracking the title, amount, and running balance. In some cases you may want to track an individual paycheck. Tracking individual paychecks allows you to manage your budget with a finer granularity, and may assist you in determining which payments need to be made when you will actually have funds available. There's nothing more annoying than working on a great monthly budget, just to find that you don't get paid for another week and you have four bills due in two days.

2. Review your budget and identify items that you can cut back on. When I created my first budget, it included $10/day for parking, $165/mo for a car payment, $160/mo for insurance, and $60/mo for gasoline. This was a lot of money to be throwing away just for me to get to and from work. After realizing this, I got rid of the car and I now take the bus to and from work. This turned an expense of around $595/mo into only $60/mo for bus fare. If you are eating out every other day, just buying your food at the store and bringing a sandwich in can net significant savings. Drinking coffee at work, or bringing your own is much cheaper than spending $4 every day at Starbucks. Start to really look at your budget and figure out what you can live without.
   
   At this point, you should have a budget which shows how much you are spending and where your money is being spent. Hopefully, you have also identified items which can be eliminated.

3. Review your credit card APRs. Many people will give blind advice and suggest that you pay off the cards with the lowest APRs first. This can be horrible advice. If you only have one card or have consolidated your debts onto one card, then at this point you only need to worry about paying off the debts. From there, you can begin to save the money in high interest saving accounts or invest it in mutual funds; whatever floats your boat.
   
   However, if you're like me-- you've got more than one card open, and the credit card companies are doing everything they can to prevent you from consolidating the debts. They may do anything from decreasing your limit, offering balance transfers which charge high transfer fees or do not offer competitive introductory APRs.
   
   Ultimately, the best way to determine the most efficient order to pay your cards off in is to simulate payments on each one of them. To do this, you'll need to know the APR associated with the card, it's balance, and the minimum payment structure. Some cards have minimum payments based on a percentage of the balance, but only a portion of that minimum payment is a finance charge.
   
   One important thing to remember, is that a finance charge (making minimum payments) means THROWING MONEY AWAY. Paying to maintain a balance on a credit card is not paying off a balance. Cards which make your minimum payment based on a percentage of the balance will typically force you to work on paying off the balance. For example, if you have a balance of $1500 with a minimum payment of 4%, but your APR is only 1.99% you may be forced to pay $60 as a minimum payment but only $2.49 of that is a finance charge. The rest of the payment is actually going towards reducing the balance.
   
   Once you determine the best order to pay the cards off, only work on paying one off at a time. Then pay the minimum balance on the other cards. If done properly, you will save more money this way. If you split your payments up on the cards then all you are doing is keeping multiple cards open for a longer time, which gives the banks a longer opportunity to charge you high interest finance charges.

4. When a credit card company charges a percentage of your balance, this is generally a minimum charge of that percentage. In our previous example:
   
   Balance: 1500
   APR: 1.99
   Min. Payment %: 4
   
   Finance charge = (1.99 / 1200) * 1500 = 2.4875
   Note: The 1200 is to turn the APR into a rough APY percentage
   Min Payment = (1500 + finance charge) * min payment %
   = (1500 + 2.4875) * 4% = $60.09
   
   So to simulate payments you'd take the initial 1500 and subtract whatever payment amount you'd be making on the card, and then doing the calculations again. Repeat this process until the balance reaches 0, then move on to the next card. Be sure to keep adding up the finance charges across all cards. Then change the order that you are paying the cards off in, and see which order gives you the lowest amount being paid to finance charges. Once you find that order, that is what you'll want to pay the cards off in.

Tips & Warnings

• Finance charges are a waste of your money. They go directly to the credit card company, and do no go towards paying off your balance.
• It is not always best to pay off the lowest balance credit card first. Likewise, it is not always best to pay off the highest APR card first. You need to take both your balance and APR into consideration before deciding which to pay off first.
• Get a copy of your credit report. Accounts in collections can generally be disputed to have them removed from your report if they are actually questionable. For example, there was a collections account on my report from several years ago. They never tried to contact me about it, they would not answer my calls, and it was in regards to a debt that Cingular claimed to have refunded. It was removed as a fraudulent entry.
• Try contacting your card companies to see if they will give you balance transfers which have no transfer fees. This will enable you to consolidate debt, if your credit limit allows it.
• Contacting companies who call your creditors to negotiate your debts may net you in trouble. Credit card companies are not obligated to honor any agreement made between you and any debt elimination programs. However, many debt elimination programs will tell you that you need only pay a lower amount than you originally were, and months later you may find that you have defaulted, are in collections, and have an APR over 30% with a crippled credit score.

[mdue]

on 8/24/2009 Great article!

[lilolladystuff]

on 6/6/2009 Good advice. Thanks.