Debt can be a manageable component in a financial portfolio, or it can be a crushing burden that significantly reduces quality of life and peace of mind. Some financial advisers, therefore, will speak of lowering a client’s debt to a level where its impact on cash flow is minimal, while others insist that a drop of red ink on a balance sheet must be removed with all deliberate speed. What does it mean to get out of debt? Is there good debt and bad debt? Can debt actually improve the financial position of an individual or family? Before executing a plan to deal with debt, households should first determine where their current obligations fit into the larger scheme of financial goals and desires.
Everybody – or most everybody – wants to reside in a clean and safe dwelling, in a community where crime rates are low and schools are reputable. Absent a hefty trust fund or other means of financial independence, this desire will likely require taking on debt, if only a mortgage on a property. In a positive real estate market where home prices are appreciating, assuming a mortgage obligation appears to be a good investment in the long run…as long as the home owner can support it with sufficient income. If such debt is worth the exposure, it can serve to support a major asset even while requiring a portion of the home owner’s monthly wages. Yet even a home loan can be toxic for those with money problems. Determining whether or not money problems exist is the first step to getting out of debt.
A gut check is in order when thinking about debt. For example, if an individual or household is spending a greater percentage of income on debt payments – credit cards, for example – it is reasonable to assume financial difficulty, regardless of the reasons. Likewise, a consumer who has reached the maximum limit of extended credit while making only minimum payments to each creditor has probably mismanaged the budget somewhere along the way. Other telltale signs are late payments, collection notices and deferred health care appointments. If a job loss would immediately create a financial crisis, or a second job is required just to pay the bills once satisfied by the day job, then debt is a major problem that must be dealt with aggressively. In cases like this, debt is neither a tool for prosperity nor a necessary evil. The second step for a person to get out of debt is to modify thinking and behavior.
Wrong-headed ideas enter the mind when times are flush. Healthy paychecks and prospects for promotion may lead some to believe that expensive toys are permissible and that savings can wait. Unfortunately, such thoughts are the seeds to home foreclosure and auto repossession. Assuming an uninterrupted gravy train is dangerous. A more edifying assumption is that any given financial situation can turn on a dime, and the corresponding personal financial behavior is centered on budgetary preparedness. Aside from job loss, urgent medical care uncovered by insurance, car accidents, destruction from extreme weather and devaluation of retirement funds are events that can strike when least expected.
Before that home improvement, owners should calculate how many months of house payments they should save in the event of job loss or medical emergency. Does the food budget take into account spoilage brought on by extended power disruption? Have unexpected tuition increases been factored into parents’ financial planning? Sometimes it pays to be a pessimist. Realistic budgeting and staying focused on building reserves prevent further hemorrhaging, allowing debtors to concentrate on the third way to get out of debt: starting small.
Food is necessary for the body, but lethal just the same. The glutton who tries to shove more food into his mouth than his throat can handle will choke to death. In the same way, the new and zealous debt reducer may crash and burn trying to eliminate too much debt at once. Instead, a prudent financial steward will marshal her resources to attack one obligation at a time, preferably from smallest to largest. This decision can be based on the dollar amount of the outstanding balance, or it can be determined by the annual percentage rate (APR) – that is, the cost to the borrower to carry a balance from month to month. Remaining creditors are perfectly happy receiving minimum payments, so debt-conscious consumers should direct whatever funds their budgets allow to paying off the modest debts first. This strategy is good for the credit report and builds financial discipline incrementally. Once established, this regimen trains the debtor to live minimally, an essential habit for the fifth phase of debt eradication.
Having developed a budget to save for unforeseen emergencies – and keeping retirement in mind – a debt-ridden individual then allocates additional dollars to taking smaller debts from their list of obligations. From here, the larger bills are now in sight. At this stage, the debtor must move all extra monies in the direction of the big-ticket liabilities like car loans and high-interest, maxed-out credit cards. Whatever has not been earmarked for future exigencies, retirement or living expenses must now flow toward these grantors of credit. The pain of this sacrifice is proportional to the elation when financial freedom is achieved. Staying out of debt depends on remembering the discomfort of getting free.
By Andre Bradley