How to Get Out of Debt

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The first step on a journey of financial independence is to learn how to get out of debt. If financial independence is the sunlit peak of a mountain that we intend to climb, most of us unfortunately start at the bottom of a ravine.

That ravine is debt. You have to climb out of it before you can even begin to scale that mountain.

If you’re reading this, then there’s a good chance your personal situation involves some measure of debt, and that you want to begin your journey to get out of debt.

This article should help.

Qualifying for the Journey

Before we begin, there are a couple of things that need to happen. If the question is how to get out of debt, then the first part of the answer has to be earn more than you spend.

That first part of the answer isn’t covered in this article, because it’s a huge subject unto itself.

If your spending is greater than your income, then you need to switch that around quickly. Until you do that, you’re just digging a deeper hole for you to climb out of.

The tools for this are everywhere on this site and others like it. Budgeting, frugality, minimalism, spend-free months and spend trackers, to name a few. Once you’ve spent one month living with a positive cash flow, and you feel that’s something you can do going forward, it’s time to come back to this article and get to work on your debt.

If you’re living within your means, then there’s a second precondition: Stop spending on credit. Your spending should come out of available funds, not credit. If you have a hard time keeping to a budget, you might consider more extreme measures like the envelope budget method.

Knowing Your Reasons for Getting Out of Debt

Knowing why is more important than knowing how to get out of debt.

We’re humans. Fickle creatures at best. Your noble intentions in the evening aren’t even shared by the person you’ll be tomorrow morning. As a consequence, sticking with a plan over the long term means doing it for reasons that are particularly important to you. Otherwise you’ll fail.

That doesn’t mean you already have to have those reasons. You can find good reasons, and by repeating them to yourself, make them your own.

Here are a few good reasons to learn how to get out of debt:

Optionality

Your debt is a ball and chain. You have to make those monthly payments. As long as you owe money, you need that monthly income not only for your own expenses, but to pay off interest and capital on a loan to someone else. You can’t take any risks, for two reasons. First, you can’t take the risk of defaulting on a loan. Second, your creditors will physically prevent you from taking out certain types of risk, like moving home or borrowing to start a business, until you’ve paid off your debt to them.

Return on Investment

It’s an odd way to think about it, but paying off loans is often one of the best uses for your money, from an investment perspective. Money in your bank accounts earns nothing. Money invested in the market earns a highly volatile return that averages between 7% and 10% over the long term. Investing in paying off a credit card loan earns you whatever the interest on that debt would have been, and that’s often in the 15%-25% range.

Removing the Risk of Higher Interest Rates

Some loans pay interest at variable rates. As I write this, interest rates are at historical lows, and have been for a while. That said, when they increase (and they will, eventually), people with debt on variable interest rates are going to feel the pain. Paying that off now removes the risk of being exposed to higher interest rates later.

Financial Minimalism

I’ve mentioned elsewhere that I think contactless payments are dangerous. One of the reasons I give is that it clutters your financial statements. Your bank balance becomes a long list of small quasi-meaningless items. That makes it hard to stay aware of your spending.

When you have lots of debts, each one of those creates additional lines of information on your bank statement. Each one of those is also a separate account you need to track. Getting rid of debt simplifies your financial statements, reduces the number of transactions and reduces stress.

Get Out of Debt to Reduce Stress

Many aspects of optimizing your finances are stressful. The constant awareness of your finances. Relentless focus on spending and frugality. Ongoing monitoring of your ingoings and outgoings. You get used to it, and you manage it better as time goes by, but it’s never simple or easy.

When you eliminate the last of your debts, there’s a moment of breathless silence in the back of your mind. A singular instant in which a burden is lifted and a concern eliminated. That’s the feeling that comes with a huge source of stress disappearing. You should look forward to that. So should the people you love. It impacts you, and every conversation you have about money, and every holiday/school/home/work decision you make.

Build your Emergency Fund

You’re trying to get out of debt, so building an emergency fund might seem like sending money in the wrong direction. But the emergency fund is an important buffer on the journey to financial independence. You’ll need it to soften the blows fate and misfortune will send your way as you work towards your goal.

How much money do you need in your emergency fund? Typically, anywhere between $500 and $2000. If you’re young, a student and live with, or close to) family, you can get away with $500. If you’re a family, with a child, and a home, and a car, then $2000 is wise.

Without the emergency fund, the first bump on the road to getting out of debt will derail all your efforts. The emergency fund provides the resilience you need to make it through the hard parts.

The emergency fund comes first, it’s the starting gun to the rest of the race.

A Cascade of Debt Payoffs

Once your emergency fund is up to size, and you’re generating more money every month than you spend, you can work out how much money you have available to pay down debt each month.

If you want to get out of debt, you need to arrange this in a way that works for financially, emotionally and psychologically.

Humans are fickle creatures, and your worst enemy from this point forward is you. You need to manage yourself in a way that ensures your continued dedication to the cause. That means managing your emotions, your motivation, your enthusiasm and dedication to this objective.

What does all this have to do with how you pay off your debts?

Minimum Payments and Maximum Effort

Most debts have a minimum payment you have to make in order to not be in default. That payment isn’t optional. So every month you’ll make the minimum payment on each of your debts. You have to be able to afford at least this much each month.

You then have an amount left over, and this will go paying off a single debt, until it’s gone. Then you’ll move on to the next debt, and the next, until they’re all paid off.

But what in what order should you pay off your debts?

Ordering Debts by Interest, and by Emotion

There are two philosophies about the order in which you should pay off debts.

The most obvious approach is to pay off the debt with the highest rate of interest first. That’s the financially optimal solution. It’s called the debt avalanche. Technically, it minimizes your interest costs.

But it’s not necessarily the emotionally optimal solution. Maybe it’s not even a solution that’s realistic for you.

If your most expensive debt is also your largest debt, it could to take years to pay it off. That’s a long time to wait for the satisfaction of claiming your first victory. As fallible creatures, we know we need positive reinforcement. There’s nothing quite so positive as the feeling that comes with knowing a debt is gone forever.

The optimal way to get out of debt is perhaps, therefore, to pick the debt with the smallest balance first. If you can knock that off the table, you build emotional momentum, and that can help you carry the effort through to its conclusion.

This approach, ranking debts from lowest to highest balance, is called the debt snowball, and it’s the most popular approach to paying off debts.

Get Out of Debt: Listing Debts in Common Sense Order

The two solutions above both have their merits. The second debt has my vote as the best of the two, because it takes our characters and emotions into account. The ideal solution, obviously, is to take the best elements from each method. Let’s call this the common sense approach to paying off debt.

Of course you should pick debts that have an emotional kick to them to pay off first.

That may be your smallest debt, so you get the payoff that comes with putting a big fat line through it on your notepad. It may also be a debt that has a heavy emotional burden. That debt you took out when you couldn’t afford to pay all three of the rent, the taxes and your kids’ school.

Taking out that loan felt like failure, it felt crushing. Wiping that off the slate isn’t just progress. It’s a new beginning. It’s emancipation. It’s a light cast on a dark moment.

That loan comes first.

You also have to balance interest rates with emotion. Sure, this debt is small, but it’s going to take seven months and it’s at 4% interest. Your credit card will take twelve months, but it’s at 22% interest. The credit card comes first. Or you refinance it somehow. 22% interest is extortion.

And That’s It… How to Get Out of Debt… Sort Of.

The map is not the territory

Alfred Korzybski

I’ve given you the map. It’s a good map. It’s not an accurate representation of what you’ll experience as you try to get out of debt.

As George Box put it, “All models are wrong but some are useful.”

The debt payoff strategy I’ve described above is how it all works in theory. The theory of cash flows. They theory of personal motivation. The theory of idealized outcomes.

The reality is a little more slippery.

There will be dark moments. There will be temptations that will slip through your defences. There will be setbacks and resets and traps and failures.

It’s not about a perfect trajectory from start to finish. It’s about getting back up when you slip and putting one foot in front of the other again. It’s about using every trick in the book. Freezing your credit cards in blocks of ice so it takes an hour to get them out again. Refinancing on a zero percent credit card and then tearing it up so you can’t spend on it. Cooking every meal on a Sunday morning, when your discipline is high, so you don’t spend on food in your weaker moments during the week.

You’ll thank yourself later.

How to Get Out of Debt: Conclusion

  • Spend less than you earn.
  • Never spend on credit.
  • Know why you want to get out of debt.
  • Make all your minimum payments, every month.
  • Order your debts, in a way that makes sense for you.
  • Pay them off. One at a time.

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