For wealth to be made simple, debt reduction must be made simple. And it can be. Like any goal, having a plan is the place to start.
Creating a debt-reduction plan may seem overwhelming; it’s like seeing your first Ironman training plan. Some trainers will only show you a week at a time so you don’t throw up your hands before you even start. Other trainers lay out the entire plan.
Seeing all the kilometres is intimidating. But a good coach will remind you that you’re not going to tackle all those running, cycling and swimming distance at once. Similarly, I always remind clients that they’re not going to tackle all their debts at once.
But debt does have to be tackled to achieve financial freedom. According to this article, Australians have $18.9 billion in credit card debt. After adding in income taxes paid on income, the average American family spends almost 30% of every dollar they earn to pay debt each year.
Reducing that percentage means you can live on dramatically less and have more for building wealth. Your money stays with you, not the bank or credit-card companies. And, when you are debt free in retirement, the amount of money needed is significantly reduced.
Creating a Debt-Reduction Plan
The first step in creating your debt-reduction plan is to write it down so you can see it all in one place.
Create a list on paper or download our free Excel version (which includes the convenience of calculating some numbers automatically). Once it’s all written down, stop and congratulate yourself. Seeing the whole picture may be overwhelming, but you’re now on your way to eliminating it.
Strategies for Paying off Debt
The next step is to reduce interest rates wherever you can. Then, when you make the same monthly payment as before, your debt balance decreases more quickly since you’re not paying as much in interest.
Here are a few strategies to reduce interest rates
Call the credit card companies with the highest interest rates and ask if they will lower the rate. If you’re a good customer and have been consistently making your payment monthly, they may adjust it.
Transfer the higher-interest credit card balance to a card with a lower rate. Before doing this, look at the fee to transfer the balance, the length of the introductory rate, and the rate after the intro rate expires.
Ask a friend or family member with cash, CDs or other low-return investments for a loan that you will repay with higher interest then they are receiving, but at a lower rate than you’re paying now. They make more and you pay less. A win-win for everyone except the credit card companies.
Consider paying off high-interest debt using a lower-interest home equity loan. This is a conversation to have with a financial coach who can objectively assess your overall circumstances and determine if this is the right strategy for your particular situation.
Check your mortgage rate to see if refinancing makes sense. Again, because of closing costs and points, you’ll want to look at the big picture when considering this option.
Once you’ve adjusted the interest rates on your debt, reprioritise your payments so you’re paying down the balance on the debt with highest interest rate first. By paying this debt first, you’ll pay off your total debt faster.
But again, for this to work, you must continue making the same amount in payments every month. Like any training program or weight-loss approach, slow and steady wins when it comes to results that will last.
To summarise, when deciding which debt to pay first, I always recommend the following order:
High-interest credit cards
Pay off the mortgage debt last because the interest on your home is usually tax deductible, while the credit card debt and other consumer debt are generally not. The goal is to get the after-tax cost as low as possible.
Staying on Budget
When your debt balance goes down, it’s tempting to relax about spending. To stay on track, have a written monthly budget. (IRC’s Personal Budget Worksheet is available for free download.) Seeing your monthly income and expenses makes it easier to take control of your world, your life, your money and your emotions around spending.
Then you can decide what you will and won’t buy, and not be influenced by marketing messages and other expectations. Bottom line, if you don’t have the cash to pay for it, you shouldn’t buy it.
Why You Don’t Need to Cut Up Credit Cards
However, you don’t have to cut up your credit cards to find financial freedom. Once you retire your credit card debt and budget your expenses, you can still use your credit cards. But view them as charge cards – not credit cards – and only make purchases you’ll pay in full when the bill is due.
Enjoy the benefits – including the convenience of not carrying cash, receiving airline miles and other points, and strengthening your credit score – while staying within your budget.
Taking the First Step
Debt reduction can feel like an elephant. But once you know how big your elephant is and take that first bite, the end of the elephant dinner is in sight.