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It's uncomfortable to be in debt. No one likes the feeling of being out of control, especially when it comes to their personal finances. If you're in that situation, then you have two problems to solve: getting out of debt, and staying out of debt.
In this publication, we're going to start by talking about some of the signals that might tell you a debt problem could be on the horizon. Next, we'll explain some of the habits you can change to begin eliminating debt. Finally, we'll talk about a few of the steps you can take to stay out of debt.
Debt in America
The debt statistics in America are staggering. As of July 2011, consumers accounted for $2.5 trillion in revolving and non-revolving credit. This includes credit card debt, smaller loans for cars and boats, as well as personal loans. That's over $8,000 in debt for every man, woman, and child here in the United States; meaning the average family of five has $40,000 in outstanding credit.
Debt Danger Signals
Averages can be misleading, and the various levels of family income in the United States imply that what seems like a lot of debt to one family can easily be handled by another. Which then leads us to the question: What are some of the signals that tell us our debt load might be too high?
The list below provides examples of payment patterns, or conditions, indicating a home's debt might be leading to financial distress:
- Continuously sending in monthly payments behind schedule
- Making only the minimum payment on credit cards each month
- Running up credit card balances because cash is hard to find
- "Maxing out" credit cards, or cards that are near their credit limits
- Using cash advances from one credit card to pay the balance on another
- Using savings to pay current bills or not owning a savings account
- Inability to put any money into a savings account each month
- Living "paycheck to paycheck"
- Postdating checks
- Receiving calls or letters from collection agencies
Eliminating Debt
If not controlled, household debt can spiral out of control. Wages can be garnished, a family could be forced into bankruptcy, and even lose their home to foreclosure. In order to eliminate debt, an individual can choose one of two paths. They can start to use more self-discipline, or they can seek the help of a credit counselor. If poor spending habits led to this problem, then both of these paths will be difficult to follow.
Income, Expense, and Debt Inventory
Regardless of the path chosen, a good plan to eliminate debt will start with an inventory of sources of income, monthly / daily / weekly expenses, and a list of all outstanding debt.
- Income: this includes a careful analysis of all sources of household income. Do not include income that is automatically directed to retirement savings plans. This first pass at income should identify money available to pay for expenses each month.
- Expenses: this includes a listing of all sources of household expenses. Credit card and bank statements typically provide a good inventory of monthly expenses involving credit cards or written checks. ATM statements should provide good information on the level of cash used each month.
- Debt: this includes mortgage payments, personal loans, car loans, in addition to money owed on credit cards as well as to individual corporations such as electric and gas utilities, telephone, and cellular carriers. Debt information should include amounts owed, minimum required monthly payments, interest rates and due dates.
The above information can be used to build a household budget. While it's usually a bad idea to spend money to save money, purchasing a quality software product like Quicken can be very useful for creating a budget. At the very least, using a household budget spreadsheet is a great way to start analyzing the problem.
Analyzing Income, Expenses, and Debt
When the above inventory is completed, it's time to start studying the information. Once again, the problem will be attacked from three angles:
- Expenses: look for ways to reduce monthly expenses. The easiest way to start that process is to separate mandatory from discretionary expenses. Mandatory expenses are the "must" pay bills each month. This includes mortgage, car loans, and household expenses such as groceries and utility bills. Discretionary expenses are goods and services that make life a bit more enjoyable, but are not essential. This includes lavish vacations, eating at upscale restaurants, and many other forms of entertainment.
- Debt: not only do you want to calculate the total amount of outstanding debt, but it's important to rank, or prioritize, that debt too. Ideally, debt carrying the highest interest rate should be eliminated first. When deciding which debt to pay off, balance the cost of the debt (interest rate) with the amount owed. It's personally rewarding to eliminate one source of debt, even if it's not the most costly.
- Income: debt can always be attacked from two directions: lowering expenses or expanding income. If it's not possible to eliminate enough expenses to start paying down debt, or if the desire is to expedite the pay-down of debt, then adding to the household's income by working a part time job is a viable solution.
Now that an inventory of expenses, debt, and income has been analyzed it's possible to create a spending plan, or budget, to track the use of the household's income. Creating and maintaining a realistic budget is the only reliable way to begin the process of reducing existing debts.
Steps to Stay out of Debt
There really isn't any difference between reducing debt and staying out of debt. The solutions to debt problems are easy to identify:
- Expenses need to be less than household income
- Reduce all unnecessary expenses
- If expenses are still more than household income, then increase the money flowing into the home
Financial freedom will not just happen. Without a plan to succeed, the failure rate will be high. In addition to the household budget, the following steps will help to ensure success:
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