How to Become Debt Free

Depending on where in the world you live, and your overall financial situation, you may want to seek specialist debt advice. For example, you may be able to enter a legal arrangement to write off some debt. However, this action will involve drawbacks, which is why – if you’re considering debt write-off - you should consult an advisor who is expert in the financial laws of your jurisdiction.

For many people, though, it’s quite possible to get a grip on your personal budgeting and pay down your debt month by month. Here are the key principles for your debt reduction strategy:

• Continue to make the monthly minimum payment on each loan
• Stop using credit cards for purchases and don’t take out any further loans
• List out how much you owe on each card or other loan
• Decide the priority order for debts to pay off (see Snowball and Avalanche below)
• Set a zero based budget to include the debt payments
• Make a commitment in your mind to follow your debt reduction strategy
• Follow your budget each month until you’ve cleared your debts

Paying off the mortgage is a long-term goal for most homeowners. When looking at how to become debt free, the shorter term priority is to pay off consumer debt: credit cards or other loans, including car loans.

Debt consolidation can make your short term cash flow easier, if it results in lower monthly minimum payments on your debts. For example, if you increase your home mortgage by $15,000 to pay off your $15,000 credit card debt. However, debt consolidation may not be a long-term solution without further measures. There are some potential downsides:

• You are probably transferring an unsecured debt into one which is now secured on your house. If you default on a future mortgage payment you may put your house at risk.
• If your future monthly spending is more than your monthly income – if you do not live within your means – you are likely to build up card debt – or other consumer debt – again.
• So, you may be simply storing up a worse problem for a future time.

If you go the debt consolidation route, it’s vital to live within your means from now on – and to build your savings.

Once you’ve decided to plan how to become debt free, you’ll need to decide which debts to pay off first. The two best-known strategies are debt snowball and debt avalanche. You use the snowball and avalanche strategies to pay down your debts more quickly than the loan company requires. You are repaying early. But, while you’re making these early payments, it’s vital to pay the monthly minimum for each debt, in line with your legal obligations.

With debt snowball you pay off the smallest debt first. With debt avalanche you pay off the highest interest debt first.

Let’s say you have three credit card debts:

• $1,000 - monthly interest 1%
• $5,000 – monthly interest 3%
• $10,000 – monthly interest 2%

If you use a debt snowball plan, you pay off the $1,000, then the $5,000, then the $10,000. With debt avalanche, you’d pay off the $5,000 (3% interest), then the $10,000 (2%), then the $1,000 (1%). You pay less interest in total with debt avalanche, which is great. Debt snowball is more expensive in interest terms, but may be more appealing as you see quicker results.

Personal budgeting is a key part of planning how to become debt free. Using a method such as zero-based budgeting, you work out your income for the month ahead and then plan how to allocate this income to cover your day to day spending, as well as your debt repayments. Though you will have quite a few sub-categories in your budget, you will always have three major categories:

• Necessities (including minimum debt repayments)
• Treats
• Extra debt repayments (or adding to your savings accounts)

In addition, your budget should be based on the following principles:

• Live within your means (do not spend more than your income)
• No more purchases on credit
• Be sure to make your monthly minimum payments on each debt

If possible, limit your spending on necessities and treats to 80% of your income, so you have 20% left to pay off debts or build your long-term savings. In the end, it doesn’t matter whether you use the snowball method, the avalanche method, or some other strategy of your own choosing. What does matter is that you keep on paying down your debt month by month until you are debt free.

When you are in debt, you have to use some of your income to pay off what you enjoyed in the past. But, once you are debt free, you can allocate all your income to funding your current lifestyle and saving for your dreams.