After reading my update about my Outstanding Debt as of June 2008, Kate left this comment:
I applaud you posting your progress for the world. Have you shared your process yet? If you have, let me know the link, I’d like to read it. So far my favorite has been Dave Ramsey’s debt snowball effect.
I thought this was a good question, so rather than respond by leaving another comment, I decided to respond by writing a blog post.
First, you should know I’ve written three posts explaining my view on how to get into — and out of — debt:
I confess I haven’t studied Dave Ramsey much. But I’m familiar with his concept of the “debt snowball.” It’s the same concept as John Cummuta’s “accelerator margin.”
In both cases, you focus on paying off a low-balance, high-interest card as quickly as possible. Then you take the minimum payment you were paying toward that account and apply it to the next balance.
As each new line of credit is eliminated, the amount of money you can use to pay down debt grows, which accelerates the speed with which you can pay off debt.
While I fully endorse and support this approach, I take a slightly different view because I’m self-employed. I don’t have a regular paycheck.
So the common advice to create a budget and stick to a rigid repayment plan doesn’t work for me because my income fluctuates month-to-month, as do my expenses.
With that as background, here’s the “system” I’ve used to pay off debt since October 2007. This is the same approach that’s allowed me to reduce my debt by 33% in a period of 7 months — from $75,286 (in November 2007) to $50,343 (in June 2008).
Step #1: Commit to Getting Out of Debt
We all get into debt in a similar fashion. It starts with a few innocent purchases and then spins out of control.
In a sense, we are all a bit like the frog who is boiled to death slowly. By the time we realize how hot the water is getting, it’s almost too late!
For me, my commitment to pay off debt began when a credit card company jacked up my interest rate. This alone was bad, but it was made worse because I felt it was unjust.
As I made phone calls and found out how powerless I was, I realized my best and only recourse was to pay off the credit card and never do business with the company again.
To say I was livid would be an understatement.
But rather than internalize my anger, I translated it into a commitment to become debt free — and a virtuous cycle of daily action to pay off debt as quickly as possible.
So the first step for me was making the commitment to become debt free.
Step #2: Get a Grip on Your Spending
I’ve never been an out-of-control spender, but I still had plenty of “fat” to trim from our monthly expenses.
Since I’m self-employed, I have a number of recurring monthly expenses to pay for business tools, education, etc. I examined these expenses first and canceled anything I wasn’t using or didn’t need anymore.
The biggest decision for me was firing my brother. That freed up $2,500 a month. And while this was a difficult decision, it worked out really well for both my brother and for me.
After analyzing the business side, I moved to the personal side. We canceled our YMCA membership. We cut back on our Starbucks visits. And we adopted a mindset of not buying things unless we truly needed them.
So we’ve made some minor (and some major) changes in how we live and how we spend our money. This has freed up cash flow that we now use to pay down our debt.
Step #3: Liquidate Possessions of Value to Cancel Debt
After eliminating expenses and getting a grip on our spending, I focused on how I could make the biggest dent in our debt with as little effort as possible.
The answer: Sell any items that we had used as security for a loan.
Secured loans are usually given for cars and houses. In our case, we had loans secured by a van, a motorcycle, and a house.
So I sold my motorcycle (even though I didn’t want to). And we even sold our house and got a rental near our parents. (We still have the van and the loan attached to it.)
The sale of the motorcycle reduced our debt significantly. What’s more, it freed up $344 a month that can now be used as an “accelerator margin” to reduce other loans.
And by selling our house and getting a rental near our parents, we reduced our housing expenses by at least $100 a month — while getting an extra 300 square feet of living space at the same time.
Step #4: Consolidate High-Interest Debt into a Low-Interest Loan
Personally, I find it very troublesome to juggle multiple credit cards and loan balances. The more of them you have, the easier it is to overlook a statement or bill and get slapped with a late fee and a higher interest rate.
So in addition to paying off certain loan balances, I also consolidated a couple of high interest credit cards into a single fixed interest rate loan from Prosper.
I chose a Prosper loan because it was a fixed interest loan with a firm start and end date.
Although I’m not against zero interest offers from credit cards, I personally choose to avoid them when possible. I do this because zero interest offers come with a whole host of stipulations.
By making your minimum payments, you will probably not be able to pay off the balance by the end of the zero interest period. And if you’re even one day late with your minimum payment, you’ll be greeted with a new interest rate so high it’s criminal.
Furthermore, zero interest offers are designed to get you “stuck” with an even higher balance.
Basically, if you do a balance transfer to a zero interest card, and then continue using that card to make purchases, you become subject to a “hierarchy” of how the balance is paid off.
Every time you make a payment, it will pay off some of your zero-interest debt, but none of the debt that’s accumulating interest charges. So if you transfer $5,000 at zero interest… and then charge $1,000 in new purchases… you will have to pay off the $5,000 balance first before you can pay off the $1,000 balance.
This allows the credit card company to charge you 18% or 25% interest (or whatever) on that $1,000 new purchase balance for a long time.
You can use this information however you want. The key thing is to reduce the number of loan balances you’re paying and to consolidate them (if possible) into lower interest loans.
Step #5: Increase Income & Use It to Pay Off Debt
The fifth and final step of my personal system for paying down debt is to increase income. This is one of the most overlooked but highly effective opportunities for getting out of debt fast.
Basically, I have looked for ways to create more value for my clients, customers, and subscribers. This has directly increased my income during the last six months.
If you have a job, perhaps there’s something you can do on the side to earn a little extra money. You can sell stuff for cash, start a tutoring service, get involved in network marketing, or even embark on a new self-employed service career.
And if all that sounds like too much work, start by holding a garage sale.
Sometimes, all you need to do is take a little step to get started.
The way I see it, every single step in my system is important. But you can only reduce your monthly expenses so much. There is a limit to how little you can live on.
On the other hand, there is virtually no limit to how much you can earn. So Steps #1-4 are more important in the early stages of your debt reduction journey, while Step #5 becomes more important as time goes on.
Because, ultimately, increasing your income could have the largest impact on your ability to get out of debt.
These are the 5 steps in my personal system for paying off debt. Perhaps they will be of help to you as you seek to become debt free.
Check it out… my post “A Brief History of Grass Lawns” was just selected as an Editor’s Choice in the 146th Carnival of Debt Reduction: