Makin' Money

Four steps to managing personal debt

Chris Farrell Aug 5, 2011

Over the past several weeks Washington put the country through a crazy, bewildering shoutfest over the federal debt. Gnawing worries over the worth of sovereign debt in Greece, Portugal, Spain, Italy and Ireland suddenly erupted into a full-fledged market panic that erased some $4.5 trillion in global equity value on Aug. 4.

Lost in all the heat over government debts is how much progress American households are making in reduce their debt burden. It isn’t easy. There aren’t any shortcuts. It’s classic back to the basics finance.

Wise Bread is an engaging personal finance site–a community of bloggers–that works at helping people live well and frugal. Philip Brewer is a regular contributor, at least when he isn’t writing science fiction and fantasy stories. He has four steps for dealing with a debt problem.

Philip Brewer: 1. Take Control of Your Cash

Control is about knowledge. Do you know how much money you’re going to spend this month? If not, your cash is out of control.

Make a list of regular payments (rent, utilities). Take a stab at irregular payments (clothes, booze). In ten minutes you should have a rough sketch of this month’s spending.

2. Generate Some Headroom

Once you know how much money flows out, compare that with your income. If you’re spending more than comes in, it’s time for some emergency belt-tightening. The first priority for managing your debt is to stop increasing it.

Once you have a gap in your favor, work to increase it. The larger the gap, the faster your debt will go down.

Maybe you can earn more, maybe not–but anybody can spend less.

3. Create a Minimal Emergency Fund
Once you have some headroom between income and spending, accumulate a little cash.
The standard emergency fund with six month’s spending is the wrong choice if you have debts, but zero is also the wrong choice–any little glitch could wreak havoc with your finances.

One month’s spending, or at least enough to cover your largest regular bill, is reasonable.

4. The Standard Snowball
Once you have an emergency fund, start to pay down your debts: Make the minimum payments, except that one debt–the debt you’re going to pay off first gets that plus all the rest of your spare cash. Once that debt is paid off, its minimum payment gets rolled in and used to make accelerated payments on the debt you’re going to pay off next.

The name comes from the way the payment grows larger–snowballing–as each debt is paid off.

How do you pick which debt to pay off first? It doesn’t matter. Cheapest is to pay off the highest interest rate first, but starting with the smallest first lets you see the snowball effect in action sooner.

For any debts you can’t eliminate quickly, it’s worth trying to get better terms. Call and ask if they’ll reduce the interest rate. If they won’t, try to find a lower-rate card you can transfer the debt to.

The key to eliminating your debt is to stay focused on your goal. Do not celebrate your first paid-off credit card with a shopping spree.

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