Debt-Payoff 101: The Basics of Getting Out of Debt
3 min read
Society tells us that debt is a good thing, but the truth is that debt holds us back from achieving our financial goals and dreams for our lives. That's why I want you to be debt free.
If you desire to get out of debt for good, you have come to the right place. Today, I'm giving you a step-by-step plan you can follow to fully pay off your debts and achieve financial freedom.
What is Debt?
I'm amazed by the amount of people who don't know what debt is. Seriously! They'll think one credit card is debt but their car payment isn't debt. Nah, fam! It's all debt. So, I'm gonna break down what debt is, so there's no confusion.
According to the Oxford dictionary, debt is something (typically money) that is owed or due and must be paid off by a deadline. Common examples of debts include mortgage loans, car loans, student loans, and credit cards.
The good debt vs. bad debt myth
Today, a lot of people think there are two categories of debt: good debt and bad debt. Good debt might be considered things like student loans. We tell ourselves they're good debt to justify paying too much for our education. We even consider a credit card as good debt if we only use it for emergencies. Well, I don't mean to hurt anyone's feelings, but there's no way student loans and credit cards are good debt. In fact, there is no such thing. The idea of good debt was pushed by banks to get us into debt so we can pay high interest rates.
Well, no more. Let's go through each common type of debt.
In general, credit card debts are unsecured debts. Companies offering credit cards charge high interest on unpaid amounts and require a minimum monthly payment. Sometimes debt consolidation can be considered to manage your debt, but it's often a ploy to get you to pay more interest over time, so beware.
A student loan refers to an unsecured debt but is considered good debt because it will hopefully help you earn a higher salary. False! Usually, you have to start paying back the loan and interest within 4-6 months of graduation. However, interest may still accrue during this so-called grace period. Currently, we are in a student loan debt crisis. We owe trillions (with a T) in debt to the government, and that doesn't include high-interest private loans owned by banks.
High student loan debt is the root of why so many millennials are financially behind where their parents were at their age. Doesn't sound so good does it? But no sweat, we're paying that stuff off. Stay with me.
Personal Loans and Payday Advances
Personal loans may be taken to cover the costs of all kinds of things, like renovating your home, paying bills or consolidating debt. Depending on the circumstances, these loans can be secured or unsecured, and often have high interest rates. Interest rates on these loans may be fixed or variable and vary greatly based on the lender and your credit history.
Mortgage loans are secured and backed by your home and are the only debt that I'm okay with you having. With these loans, you agree to pay it back in installments, for example, biweekly or monthly, over a specific time. If you cannot pay your mortgage, your lender can foreclose on your home.
If you want to buy a vehicle but you aren't able to afford the full amount, you may take a car loan. Car loans are secured debt meaning your car can be repossessed if you default on payments throughout a certain period.
Car loans are also a massive waste of money. If you're in the market for a car, ditch the debt and buy a quality used car in cash.
How to Get out of Debt
Now that we've established what debt is. Here's how you get out of debt.
Step 1: Determine why you want to get out of debt.
Answer these questions honestly:
- Why do you want financial freedom? Is it so you can travel the world?
- Is it to relieve financial stress
- Is it so you can break generational poverty in your family?
I want you to be honest with yourself. Why? Because getting out of debt is hard work. A compelling "why" will keep you on track when you're tempted to quit. Write it down and remind yourself of it on a regular basis to stay motivated on your debt-payoff journey.
Step 2: Understand how you got into debt in the first place.
Remember that list of debts we went over? Time to look at those again, and do some soul searching. Why? because when you understand how you got into debt, you can better understand how to get out and (most importantly) stay out.
According to a Lending Club report, by May 2022, 58% of Americans — around 150 million adults — live paycheck to paycheck. That's because they have too many monthly payments and not enough income. According to the Bureau of Labor Statistics, the average salary in America is about $54,000. However, the average consumer debt sits at $92,727. The amount includes auto loans, credit card debt balances, mortgages, personal loans, and student loans.
Think about those two stats. Most Americans are living check to check and their income is less than their expenses. When I read that, I think that there are millions of Americans out there living above their means. People spending money they don't have to impress people they don't even like. Look honestly, at yourself and your spending habits. Did you really need that brand new car or were you trying to keep up with the Joneses? Do you still wear that expensive bag you bought or was it just because you saw your homegirl with one?
You gotta address those issues if you're gonna get out of debt.
Step 3: Make a monthly, zero-based budget.
I'm all about budgeting, and you should be too. Creating a zero-based budget means when your income minus your expenses equals zero. For example, if you make $3,000 a month, anything you give, save or spend must add up to $3,000. If it doesn't, you need to assign that dollar to one of the categories in your budget.
Track your spending throughout the month. Every amount that comes in must have a purpose, a job, and a goal. Nothing should be left hiding or getting mindlessly spent on fancy deals.
You can achieve zero based budget by:
- List your monthly income. Try using a free budgeting app like EveryDollar.
- List your expenses. Make a list of everything you spend money on during the month. These expenses must include giving, savings, utilities, food, grocery, and gas.
- Subtracting your income from your expenses to equal zero. By subtracting all the expenses from your income, it should equal zero. If you don't get zero at your first pass, it is fine because, in step 4, we talk about how to fix it by prioritize paying your debts.
Step 4. Follow Dave Ramsey's 7 Baby Steps and the Debt Snowball method to pay off debt.
1) Save $1,000 Starter, Emergency Fund.
Start by putting away $1,000 for an emergency. Your emergency fund should be in a checking account separate from your regular account. These savings are "for the unexpected events in life that you don't plan for," as my boy Dave Ramsey says. When you save and place that money in a separate account, you will be ready for that expense when the time comes.
2) Pay Your Debt with The Debt Snowball Method
List debts from smallest to largest and attack from the smallest debt first by paying off as much of it as possible, as you make minimum payments on the rest. Dave also says to not pay attention to the interest rates unless there are two debts with similar payoff amounts. Only then can you pay off the higher interest rate first.
Once the smallest debt is paid off, use the minimum payment amount for that debt plus any extra money you have to pay off the second largest. Continue until you're completely debt free! When you pay off a single debt, it is better than partially paying off several debts.
3) Save A Fully Funded Emergency Fund
Start by saving 3-6 months of expenses for emergencies. Begin by asking yourself what it would take to live for three to six months if you lost your income. You never know what the future will bring, so it is always a good idea to be prepared for bad luck.
4) Save 15% for Retirement.
Fifteen percent of the household income should be invested into Roth IRAs and pre-tax retirement funds. Begin by investing more in your company's 401(k) plan so that you will receive the full employer match. Proceed to invest the rest into Roth IRAs by investing one for yourself and one for your spouse if you're married. Dave further advises that you spread the money across four types of mutual funds: growth, aggressive growth, growth and income, and international.
5) Save for Kids' College Fund.
Dave advises that if you're saving for college, you should use Educational Savings Accounts (ESAs) and 529 tax-advantaged savings plans, known as qualified tuition plans.
Don't use insurance, savings bonds, or pre-paid tuition. He adds that you should pay cash and avoid college loans as much as possible.
6) Pay off Home Early
Put all the extra funds based on creating a solid budget for your mortgage and get it paid off as soon as possible. That will ensure that you pay less interest and less interest which means you will have more money to give to worthy causes and to fulfill your dreams. Dave advises that if you have a 30-year mortgage, you should consider refinancing to a 15-year, fixed-rate mortgage.
7) Become Wealthy and Give generously
At this point, you don't have debts, not even a mortgage. With no debt, it means
you can truly live and give to causes that you can be passionate about in your
community and in the world.
Step 5: Live Below Your Means.
Living below your means is a critical financial move that can help you to:
- Have extra money to invest or save by spending less than you earn.
- If you have credit card debt, the process will free up more of your money so you can throw it at your debt.
I know this isn't always easy, so here are some ways to live below your means:
1) Use cash. When you run out, you can't spend anymore.
You are less likely to overspend when you use cash instead of credit. If you have no cash, you simply can't keep spending. This forces you to live within your means and stick to a budget.
2) Save for big purchases. Ditch the payment plans, save up for big purchases and pay cash.
Saving up for big purchases is a great way to live below your means. When you pay cash, you know exactly how much money you have to spend, and you are not saddled with debt.
Payment plans can be tempting, but they often end up costing you more in the long run. Interest charges and late fees can add up quickly, so it is always best to save up for purchases ahead of time.
3) Grow your emergency fund.
Living below your means helps you to save and weather financial emergencies. For example, you can pay for unexpected expenses like ER visits or car repairs.
4) Get off of social media.
Spending more than you have when you see your family and friends buying expensive things is tempting. Turn off the distractions from time to time to clear your head and focus on your goals. Put that extra time into managing your finances and working on ways to earn another stream of income for your family's income to grow, save and invest.
So, if you're looking to get ahead financially, start by living below your means.
Listen, if you follow this advice, you're guaranteed to get out of debt. And that means you're closer to financial freedom and establishing generational wealth for your family.
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