Feature Article: Live debt-free - even while you are still in debt!

According to figures recently released by the Federal Reserve, consumer debt is at an all time high, at $1.98 trillion in October 2003. Are you in one of the 60% of all households in the US that carries a balance on one or more of your credit cards? Is your outstanding balance less than or greater than the average $12,000 debt in these households? Are you paying $1000, $2000, $3000 or more in credit card interest per year? Think what you could do with an extra $2500 per year – for many people, this is the equivalent of an extra paycheck (or even two) after taxes.

The tragedy of overwhelming credit card debt goes far beyond the financial cost: in the physical and emotional toll caused by lack of sleep, stress and anxiety; the marital toll of constant arguments over finances; the time and attention taken away from not only your work but life’s pleasures as well. If you are in credit card debt, it’s very likely you are putting your life on hold until the bills are paid off – feeling that you can’t take a vacation or repair the roof or fix up the kitchen, even see the dentist, until you get rid of the debt.

Most people in debt underestimate its impact on their lives emotionally, physically and even financially. Debt is almost never an isolated problem you can fix with a good consolidation or refinancing plan; rather it’s an indication of how you have lived your life, how you make choices every day; it’s a symptom of deeper problems. You'll never manage to become debt free, and stay debt free, until you confront – and change – the behaviors, patterns and values that put you in debt to begin with.

The good news is you don’t have to wait until you have paid off all the debt to start living again. Follow the seven steps below – and avoid the three major mistakes debtors make – and you too can live as if you are debt-free – even while you are still in debt.

Step 1: Stop incurring new debt. It sounds so simple and obvious, but for those in debt, it can be very difficult, especially when confronted with unexpected expenses. However difficult, this is essential – cut up the plastic, take a pledge to stop relying on your credit cards to get you out of financial jams or help you buy things you can’t afford. This is the number one mistake made by people in credit card debt: they don’t stop using credit cards.

Step 2: Get very clear about your financial situation. First, take a deep breath and get a good look at your debts. Collect all of your most recent bills and, on a sheet of paper or in a spreadsheet, list each and every debt (except secured loans like mortgage or car loans) and how much you owe on each (see the Money Tool of the Month in this issue for more details). Next, get clear on your income and expenses – track all expenses and income in detail for at least two weeks, a month is better. Once you have a very clear picture of how much is coming in and where the money is actually going each month, then, and only then, you are ready to proceed to the next step.

Step 3: Set up a realistic spending plan. Use the information you’ve gathered in Step 2 to look realistically at income vs. expenses for the month and to make hard decisions on what, if anything, you can reduce or do without. This is the second of the three big mistakes people make – setting up an unrealistic plan, based on “I think” rather than fact, resulting in unrealistic expectations about how much they can afford to pay down on their debt each month. Another reason for an unrealistic plan is cutting back too much: carving into real needs, like dental or eye care or avoiding purchasing new clothes when your old ones are really shabby. This leads to a feeling of deprivation that will, sooner or later, sabotage your commitment to not incur new debt by increasing the urge to spend impulsively. Unfortunately, the impulse buy, when you finally give in to it, is usually for extras, not on things you really need. Who “impulsively” goes to the dentist?

Finding it difficult to cut? Another option is to find ways to make more income. Or sell something you don’t use and won’t miss. Often, I find these options are not seriously considered or are completely ignored, but they were relied on much more by our parents’ and grandparents’ generations, before the advent of easy credit. Believe me, without the option of using credit cards to meet your needs, you will get very, very creative in finding more money and cutting costs.

Step 4: Start saving money. Notice this is a step before deciding how much you can pay each month on your debt. The third of the three major mistakes made by people in debt is putting every spare dollar against the debt, without allowing for savings. The only way you can avoid using credit cards for large, periodic expenses, like car or home repairs or the holidays, is to save up for these expenses. I realize this runs counter to conventional wisdom – if you have any savings, “they” recommend that you should use it to pay down the debt, and don’t save until all the debt is paid off. Speaking strictly on an interest rate paid vs. earned basis, “they” are right.

However, we’re talking here about changing habits and reducing stress; nothing reduces stress more for people in debt than knowing that they have some cash savings in case of an emergency. A regular monthly savings habit is the backbone of getting, and staying, out of debt and of building a secure financial future as well.

Step 5. Develop a strategy to pay off each debt. Finally, it’s time to identify where the money is going to come from (reduced expenses, increased income or both), how much you will apply to your debt each month, and how long it will take to pay it off. Once you’ve determined the total amount you can apply to your debt each month – realistically, taking into account savings for periodic expenses and making sure all basic needs are covered first – then build this amount into your monthly spending plan and stick with it, month after month, until all unsecured debt is paid off.

There are a number of options out there that can help you pay off your debt faster; most involve lowering interest rates. These include refinancing your home, which can be risky – you are turning an unsecured debt into one secured by your home, and if you cannot make the payments, you are putting your home at risk. Another option, if your credit rating is still good, is to consolidate your debts into one loan with a low rate. You can also negotiate directly with your creditors to reduce interest rates; if one won’t do it, you can move your balance to a lower-rate account (assuming you have good credit).

Once your interest rates are as low as possible, what are other strategies to pay off the debt quickly? Some people pay off the highest-rate debt first; others prorate what they can pay each month across all debts. What’s most important is to see results. I recommend making the minimum payment on all but one debt and paying the remainder of the money earmarked for reducing debt on this one debt until it’s paid in full. Then, when that account is paid off, take the amount you were paying on it and add that to the minimum monthly payment of the next debt you want to pay off. This way, you will have the satisfaction of retiring the accounts one by one and have fewer bills come in the mail. How to pick which account to start with? The one with the highest interest rate makes sense; alternatively, apply it to the account with the smallest outstanding balance, to eliminate a bill more quickly. Either way, the feeling of progress is a powerful motivator to stay with your strategy.

The satisfaction of seeing total debt, and the number of debts, go down, along with the security of savings for upcoming bills and knowing that you’re meeting all of your basic needs, greatly reduces the stress of being in debt and soon, the debt payments become just another bill to pay.

Want to not only get out of debt, but stay out of debt forever? Go on to Step 6.

Step 6: Learn from your own financial history by doing a “debt inventory”. Take out the list of your debts. How was each incurred? If one or more credit cards are maxed out, how did they get that way? What was the most expensive thing you purchased on credit in the last six months? Has having this item impacted your life, and if so, how? Would your life be different if you hadn’t purchased the item? Did you plan on using your credit the way that you have, or did it “just happen?” What were your intentions? Spend some time reflecting on the answers, learning what you can to avoid repeating past behaviors that created debt.

Step 7: Eliminate your debt. By working with a realistic spending plan that includes savings for periodic expenses as well as debt reduction, you will see progress and feel your anxiety fading. Now is the time for real discipline. Most people who get out of debt fall right back in, again and again. There will be a strong temptation, as you see progress and your stress is lowered, to “just charge a little, after all, I’ve been so good.” Don’t give in! This doesn’t mean depriving yourself of the things you’ve been putting off. Just be sure to work them into your spending plan so you can pay for them out of current earnings. A prioritized list of those needs and your strongest “wants” will help you to fill in areas of deprivation in an intentional and planned way without incurring new debt.

Whatever your specific plans for paying off your debt, if you have a realistic spending plan in place to meet your needs, save money, and make a regular payment on your debt, you can live as if you’re debt-free, even while you pay down your debts.

By Kim Corwin, CRFC, AFC, founder of New Leaf Financial Counseling