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Sunday, February 15, 2009

How to get out of debt

I always tell people the first step to getting out of debt is to not even consider money.

First, I want you to sit down and imagine your ideal lifestyle. If you are married, have your spouse do this too. Do the exercise separately then compare notes. Yes, write down your vision. How will you spend you day? What hobbies will you enjoy? What will your house look like? How will you live? What kind of relationships will you enjoy? What is most important to you?

Next examine your current lifestyle. How different is your current situation from your ideal? What do you need to change? What can you change now? What will change in the future?

Our financial life is just a small part of our overall lifestyle. However, our current financial situation can greatly affect the opportunities that we can afford to take. If your dream is to become a freelance writer but you are the breadwinner of a large family who needs employee benefits like medical insurance then you are going to have to take several steps to strengthen your financial picture in order to live your dream. On the flipside, if you already own a huge McMansion and your dream is to live in a quiet, rural cabin then your dream, including a debt-free lifestyle, may be as close as finding a qualified buyer.

With a firm vision of your ideal lifestyle, put pencil to paper (or fingers to Excel spreadsheet) and WRITE DOWN all of you debts, fixed obligations and all of your assets. You can also use one of the many financial software packages, like Quicken, to help you. However, I also recommend writing a separate list of the debts that you want to pay-off. List the total debt, the interest rate, your minimum payment and the due date.

Before you start paying off debts, look at the assets side of the equation. The first rule in debt pay-off is to 'stop the bleeding'. You needs enough assets - savings and investments - to dip into should an emergency arise. If you don't have an emergency fund then you'll find yourself using your credit card to avert disaster. If you don't have any savings, then you need to concentrate on saving FIRST, then look to pay off your debts.

The next step in 'stop the bleeding', is to STOP using the credit cards or otherwise adding to your debt. If you can't contribute to your savings because you're using your income to cover your unexpected expenses, that's fine as long as you aren't adding to your debt as well.

At this point, many people say, "But I don't have any money to save!"This is a cash flow problem - you have more money going out than you have coming in. The only solution is to either increase the money coming in or decrease the money going out.

Look at your tax withholding. Do you get a refund every year? If so, reduce the amount that is withheld from your paycheck. You need that cash in your pocket NOW, not later. Can you take on a second job or find some other source of income? Can you do more work for your current employer to get extra money? Can you sell some of your assets, such as a second (or third) car or unneeded household items? Put that money into savings.

Look at your fixed expenses. These expenses aren't as 'fixed' as one would think. Can you increase the deductible on your insurance to save on premiums? Can you can cancel unneeded services such as cable or cellphone? If money is really that tight, a Netflix or Tivo account is not a necessity.

Start writing down EVERY penny you spend day to day. Money tends to run through our fingers like sand through a sieve. Look at what you're spending your money on and see where you can cut back.

There are a multitude of suggestions on how to spend less. Some people have even written books about the subject. Go to the library, check out a few books, and start reading.

Once you are spending less than you are taking in and have gotten into a habit of saving money, then it is time to pay off debt.

Start paying off the highest interest rate debt first. Sometimes, I recommend that people start with paying off a few low balance debts first. It is psychologically uplifting to get that 'early win' and see those debts float away. After that, definately pay off the highest interest rate debt first. No, do not withdraw money from savings to do this. Once that debt is paid off, 'snowball' your debt payoff by adding the money that would have gone to the first debt to payoff the second debt. Pay off the third debt by dedicating the money that would have gone to the first and second debts to that debt. Soon, all the other debts will get paid off much faster.

Finally, when all your debts are paid off, increase your savings and investments even more and continue to work toward your fulfilling your dreams.

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About Me

A little about the author ... I'm known as Cookie. I'm a long time frugal fanatic so when I shop, I prefer to save money. There is no reason to spend more than we have to! However, I also appreciate convenience and fine living. I strive to strike a balance between a nice lifestyle, simplicity and frugal living. I work hard for my money so I like to make my money work hard for me.