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One of the great benefits of living cheaply is that, over time, you eventually get to live a life free of debt. In the early years, it's alright to have a mortgage or have a car loan but most cheapsters, young and old, pay their credit cards in full and avoid consumer debt like the plague. But, for whatever reason, people do get into serious debt and when they reach their credit limits, they find themselves obliged to do the tough work of digging themselves out of the hole. If you are wondering how to get out of debt, read on:
Identify How You Got into Debt:
If your credit card balance is $25,000 and your annual income is $60,000, nobody needs to tell you that you have a problem - you know that already. But do you know how you got there? Resist the urge to put together a debt reduction plan before spending a little time figuring out how you got into the situation in the first place.
It might take a bit of time to get the paperwork together and break down the numbers. Your credit cards may have a mix of everything from groceries to luxury vacations. But there are a couple of key things to look for when you're going through this exercise.
- Determine how long it took to get to your present level. Was it 5 years or 5 months?
- Figure out the major non-essential expenditures you charged to your card. If it took you a while to build up your debt level - on average, how much were you putting yourself in the hole every month
Armed with this knowledge, you will be able to take the appropriate action to reduce your expenditures.
Income to Debt Ratio:
A good rule of thumb for your credit card debt is to take your debt and divide it by your annual household income less $20,000. So if your debt is $20,000 and you make $80,000 a year. You ratio is $20,000 / ($80,000 - $20,000) = 33%. The rationale for subtracting the $20,000 is that it's the absolute bare minimum income you would need for housing and food. If you make this amount or less, you really shouldn't have any credit card debt.
We are just looking at credit card debt here. The reason that we aren't looking to automobile debt or mortgages is that those are asset backed debts. Theoretically, you could sell the asset and eliminate the debt. Not so with credit cards. The problem with credit card debt is that - as it piles up - it increases as a percentage of your income. And the higher that percentage, the harder it gets to pay it off.
Debt to Income Ratio and Changes Needed to Pay Off Debt in 3 to 5 Year Period
0% - 15% - Modest, minor expense reductions should eliminate debt
16%-25% - Going to be somewhat painful to reduce this amount over a 3 to 5 year period
26%-35% - Get ready to make some very big changes to your lifestyle
36%- 50% - Massive changes in expenditures needed. You might have to generate additional income or sell some of your assets.
51%+ - Potentially unrecoverable unless you are able to sell assets, boost income, or negotiate a settlement to credit card debts. Seek out professional assistance unless you have assets to sell or use.
To be in the last two categories, it is likely that you had a very big event - medical expenses or salary reduction. The higher your debt burden is as a percentage of your income, the more likely it is that you're paying higher and higher rates to secure additional credit.
Now that you know where you stand and how you got there, it's time to figure out a plan to get yourself out of the mess.
Cut Your Expenses First:
If you are in the first ratio category identified, find a few things that are easy to cut and divert the monies that you would spend on those to paying down your debt.
For everyone else, you are going to be obliged to take more radical measures.
It goes without saying that the first thing you should do is to avoid going deeper in the hole - resist all temptations to incur additional debt or secure more credit.
If three vacations to Mexico each year blew up your debt, then mothball your suitcases and start vacationing in your back yard. After you have eliminated the obvious, it's time to go after all the "nice-to-have" stuff in your life. And get real about what you actually need to get through the day. House cleaning, cable, Sirius radio, Tivo, gardener, Netflix, eating out three times a week, Starbucks, etc. If your debt ratio is high, you are going to need to cut a lot of these to make a meaningful difference. If there is something that you just have to have, then see if there are ways of getting it cheaper. Move to a $9 Netflix plan, cut down to basic cable, tell your housekeeper that you only need her once a month. Most of all, I recommend that you stop using your credit cards altogether and start using cash. Once you have made all of your cuts, add up how much you're going to save every month and apply that towards reducing your credit card balance - over and above your minimum payment.
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