3 Simple Steps to Pay off Debt
The average credit card debt per US household is over $7,000. The average car loan debt is over $27,000. So between two categories the average American has $34,000 of debt!! When you start adding in other categories such as mortgages and student loans the picture only gets bleaker. Right now, Americans owe 14.15 trillion in debt! That’s a huge number, but we need to put this in perspective. Let’s take a look at average total debt compared to average earnings. The average American owes $137,879 compared to the median household income of $61,937 for most recent reporting year. That tells me that there are a lot of people who need advice on how to pay off debt.
I know that debt is what keeps us from true freedom. We found that when we paid down debt we were less stressed and had freedom to make choices about our future. Banks usually want an average total debt to income ratio of 36% when they are looking to give you a loan. That’s a pretty good chunk of your monthly income and often most banks will go up to 43%. Imagine what you could do if you got 43% of your income back or even 15%!!
What is debt?
You probably already know what debt is, but let’s take a second to discuss it. The simple definition of debt is that it is money owed. To get more descriptive, debt is money that you owe because an organization provided you with their money to purchase something now that you cannot afford. You have to pay a penalty for this, and that is the interest expense that you see on your loan. Think about that for a second…. When I was a kid I was always told by my parents that if I couldn’t afford a toy than I would need to save up money in order to purchase it.
Now, I understand that life gets more complicated and sometimes you have to take on debt. However, think about if you owed a friend money. You would probably try to pay them back as soon as possible? At least, good friends would (and if you wouldn’t, maybe we should have a discussion about what being a good friend is). So, we need to treat our debt as if it is a friend that we need to pay back.
1. Create an Emergency Fund.
First off, before you begin focusing on paying off debt make sure that you have an emergency fund of $2,000. This will ensure that you don’t have to go into further debt to pay unexpected expenses. When you do use money from your emergency fund, make sure to build it back to $2,000 before moving forward with making extra payments on debt. If you haven’t already set up a budget be sure to check out our post on the subject.
2. Pay off debt using the Debt Snowball.
Now that we have an emergency fund we need to focus on your debt. If you only make the required payments on your debt you won’t get very far. Instead, you need to focus on paying off debt faster. You can accomplish this by using the debt snowball method. The method works by paying off the smallest loan amount first and working up to your largest loan. If you had three loans for $1,000, $2,000 and $3,000 you would start by focusing on the $1,000 dollar loan. Once you have paid the $1,000 loan you will apply that monthly payment to the $2,000 loan and so on until you are out of debt.
So how do you get started. First off, we are going to assume that you already have $2,000 in your emergency fund. If you have been a reader of our posts you will know that we suggest always saving at least 20% of your income. To pay off debt we are going to change the rules, until you are out of all debt or only have a mortgage loan left.
How does the Debt Snowball work?
Take the amount that you would normally be saving and you are going to start applying it to your smallest loan. *One caveat to this is if you have a tax advantaged plan that your employer does matching for i.e. 401k, HSA, etc. Go ahead and continue putting money into these accounts up to the match limit. So if your smallest loan has a $100 payment and you were saving $200 than you would now be paying $300 towards that loan. Once that loan has been paid off you will take the $300 and add it to the payment to your next smallest amount. That’s why this method is called the debt snowball. It’s like when you roll a snowball down the hill it gets bigger as it picks up more snow. That’s what happens with your loan payment amount. It gets bigger and it becomes easier to pay off your larger balances.
What I love about the debt snowball is that it allows you to get wins faster. Paying off debt is a long arduous path. You will have set backs, but getting those small wins has a significant mental impact and will ensure that you stick to your path. It is so satisfying once you see the payment amount going up.
3. Find other ways to pay off debt.
On top of using the debt snowball, try to find other ways you can get money to decrease your debt. Perhaps sell some of the junk around the house that you aren’t using. Apply any “found money” towards paying off your debt. The internet has made it easy to make money on side hustles. Another way you can get more money is by simply cutting back on your expenditures. Be sure to check out our post on ways to save money on groceries. Every little bit you can find will have a large impact on paying off your debt and gaining your freedom.
Tell us your debt stories or what has worked for you in the comments! We love to hear from you!