Believe it or not, the rules on debt and credit are brain-dead simple.
Yet, it has become the biggest personal finance problem most people face.
How can something so simple create so much difficulty in people’s lives?
In this article I explain the deceptive nature of debt problems, the simple rules to keep you out of trouble, and the best way to solve any debt or credit problems you already have…
The Real Problem Isn’t Debt…
First off, debt is a symptom – not the problem.
Tracing the problem back to its root cause works like this…
- Your money problems result from excessive spending or insufficient income.
- Excessive spending and insufficient income problems are caused by life habits.
That is why debt and credit problems are so difficult to resolve for most people. It is a personal life problem masquerading as a financial problem. You look for financial solutions but they don’t exist because you’re looking in the wrong place.
Everybody knows the cure for debt and credit problems is to make more money or reduce spending. Duhh! So what? Getting it done is the surprisingly difficult part because the solution looks financial but is actually personal.
That is why extremely popular blogs exist on this topic. We want to believe there is a missing “secret” or “insider tip” that will solve our problems so we continue to search for more information. Unfortunately, more information won’t solve anything.
The real problem is inside you – money is just the symptom. There is no magic solution because you are a complex human being.
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As a money coach I used to accept get-out-of-debt clients and it was a fascinating journey. With few exceptions the client’s financial problems were a mirror reflection of the underlying habitudes (habits and attitudes) that governed all of their behavior. Money problems were merely reflecting those habitudes financially just as other aspects of the client’s life (poor relationships, health, unhappiness) were reflecting the same habitudes.
In other words, people who ended up with credit card debt through overspending (as opposed to being caused by catastrophic events like medical bills, divorce, accident, etc.) shared some or all of the following common characteristics…
- Misplaced Priorities: They chose consumption and current lifestyle over investments and freedom. Their consumption decisions reflected the underlying belief that happiness was connected to more-better-different stuff. It’s not.
- View Credit As Money: They used credit to extend purchasing power. It doesn’t work that way (except in the short-term).
- Instant Gratification: They chose instant gratification over delayed gratification. They generally operated from the perspective of “today” and ‘this year” but failed to connect those actions to results 10-20 years later.
- Procrastination: Instant gratification leads to putting off the hard stuff until tomorrow. This multiplies short-term inconvenience into long-term disaster.
- Victim: They don’t own the source of their problems as caused by themselves. Someone else or some unfortunate event did it to them.
- Emotional Spending: They buy for ego and emotional satisfaction instead of utilitarian value. Self is emotionally connected to stuff.
- Entitlement: They are entitled to the good things in life. Why shouldn’t they have designer clothes, a big screen TV, and a nice car… everyone else does? (Answer: they can’t afford it – that’s why – but neither can most of the other people.)
- No Plan: Spending and earning are disconnected. There is no budget, no system for growing assets, no tracking of numbers, no plan for leverage, and no strategy for increasing earnings. In short, there is no discipline.
What’s amazing (and obvious in hindsight) is you can flip every one of these characteristics upside down and you have a short list of habitudes that produce wealth. In other words, my wealthy coaching clients had one set of habitudes and my debt clients had the mirror opposite.
I was amazed! But this was not a coincidence.
As I said earlier, debt is a symptom… not a cause. The cause of your financial problems is not financial (with the sole exception of unusual circumstances such as medical, catastrophe, etc.).
Now that we understand the root cause of debt and credit problems (your habits and attitudes), let’s look at some simple rules for habits and attitudes that cut through all the information clutter so you can avoid debt problems…
Proper Use Of Debt
Debt isn’t all bad.
Let’s start by looking at two acceptable forms of debt – financing large capital purchases and income property acquisitions.
For example, a perfectly viable wealth strategy using debt financing (a mortgage in this case) is to purchase a rental property that produces more income than expenses (positive cash flow).
Similarly, it can be a very smart wealth building strategy to leverage a business using debt as long as the income produced by what you purchase with the debt exceeds the cost of the debt.
These are both intuitively obvious examples of “good debt” because they put more money in your pocket than they take out while growing a valuable asset. The income produced by the asset exceeds the cost of servicing the debt. It is a straightforward application of financial leverage to multiply wealth.
The analysis gets confused when large non-consumption capital expenditures are purchased where no income is produced.
For example, debt is acceptable for buying your home. The reason is because you need housing so you either throw money away on rent in perpetuity or pay a mortgage and build equity. The key distinction is the asset has enduring value and isn’t “consumed”. It is not like a car that you use up and dispose of. It is a capital item that produces a utilitarian good (a place to live) without being used up (assuming you maintain it). It can even increase in value over time (except during a credit deflation).
These two situations (large capital expenditures that are not consumed and income producing property) are the two situations where debt can make good business sense.
These are both examples of good debt.
Now let’s look at bad debt…
3 Rules To Never Get In Debt
Bad debt is when you use credit to increase consumption beyond what you can afford to pay. The key point is the spending is for consumption – not an asset.
The rule is simple when spending on lifestyle: if you don’t have enough money in the bank then you can’t afford it.
That means the only acceptable function of credit cards is for transaction convenience. They should never by used to extend purchasing power.
In addition, you should pay your cards in full every month. Never roll a balance over from one month to the next.
Your objective is to be a credit card “deadbeat” by paying off your balance every month and incurring zero fees for the privilege of using the card.
Another advantage to credit cards are the various incentive programs that give free airline tickets, trips, hotels, and even cash back. Again, the rule is simple: only use these cards for spending you would already be doing anyway. Never increase your spending to get bonus awards.
You should never spend a dime more than you would if no credit was available and you should never carry a balance or incur monthly fees. Only then can the benefits of incentive credit cards exceed the costs (the annual fee).
I don’t promote credit cards on this site because my focus is building wealth, but if readers are interested in finding the best credit card promotions, offers, and deals I encourage you to look over these links from a couple of friends in the financial blogosphere who “eat their own cooking” and consider using the same cards they recommend…
- PT Money keeps both the Chase Freedom card and the Chase Business card in his own wallet.
- Ben Edwards over at MoneySmartLife likes the American Express Blue Cash card for his personal use.
Finally, always look first at the fees charged so that you can determine if the incentive program will give you more benefit than the costs of owning the card.
In summary, the three rules to avoid getting in debt trouble are as follows…
- Debt should only be used to finance income producing property or large, non-consumption, asset purchases.
- Debt should never be used to extend purchasing power for consumption. Lifestyle should never be bought on credit.
- Credit cards should only be used as a transaction convenience and never to extend purchasing power.
That’s it! Those are the rules that will keep you out of trouble (if you follow them) – 3 simple rules that convert the complex world of debt and credit into straightforward, actionable guidelines.
Unfortunately, for many readers it is “too little, too late”. They are already in debt. If that is you then below is an equally simple, step-by-step guide on the best way to get out of debt and start building habitudes that will take you to wealth…
How To Get Out Of Debt
If you are in debt bondage then your starting point to freedom is you must create a positive spread between how much money comes in and how much goes out.
It is an inescapable fact. You must live on less than you make. There is no way around it. It is not negotiable because debt is paid off from the income leftover after expenses are paid. You can’t pay off your debt if you spend more than you make.
The way you start this process is by fully owning responsibility for your financial problems and developing a plan for solving them.
You must be proactive. Don’t bury your head in the sand because the problem won’t go away on its own. You must take serious action. The longer you wait the worse it will get.
There are two ways to achieve the goal of living on less than you earn – reduce spending and/or increase income. Seriously, I know this sounds obvious when written but this is literally all there is to it. It is not rocket science and there is no greater complication or missing secrets than what is described here.
Let’s start with a five step process for reducing spending…
5 Steps To Reduce Spending…
Step 1 – Stem the Bleeding
Contact your creditors immediately and try to negotiate special terms. You may be surprised how helpful they can be if you just ask. It costs you nothing and the worst that can happen is they refuse.
If your existing lender won’t work with you then look into balance transfers and consolidate all loans onto the lowest interest card. Just be careful of balance transfer fees and other hidden costs. Examine the fine print first to make sure it’s really a benefit.
Your objective is to negotiate reduced rates and favorable terms to stem the bleeding. Eliminating fees and reducing interest on current debt can go a long way toward helping you ultimately payoff the debt.
Next, you must stop adding to the debt by cutting up the credit cards, locking them out of reach, or freezing them. You have already demonstrated a spending control issue so you must eliminate access to the vehicle that allows you to spend excessively – easy credit. The objective is to put obstacles between you and credit so that it is inconvenient.
Do it now before moving onto the next step. This will force you to live within your means – now!
Step 2 – Raise Awareness Through Tracking
Once credit is inaccessible and you’ve done everything possible to reduce the bleeding, the next step is to track your spending. This is not a budget. You are simply tracking where the money is going to raise your awareness…
- Is it to entertain yourself when you are bored?
- Is it on spontaneous purchases instead of planned needs?
- Is it on the latest gadgets?
- Is it on fees or interest because you are in debt?
- Do you spend for personal collections (curios, music, etc.) that you enjoy but aren’t necessary?
- How much goes to recurring expenses (rent, car payment, utilities, etc.) that can be reduced or eliminated?
- How much is wasted on fees for unnecessary convenience (ATM fees, advance ticket sales, etc.)
- Do you spend on expedient solutions that are little more than a convenience such as going out to dinner or expensive coffee instead of cooking at home (see our Latte Factor calculator for the true cost of these expenses)?
- For ego gratification (expensive clothes, latest trends, to show off to friends)?
- Name brands instead of generics?
- Processed food instead of whole food?
- Full price items instead of seasonal or sale discounts?
- New instead of used?
When you track your spending it raises your awareness about where your money goes and what your patterns are. This will point to a personalized solution that exactly fits your individual needs. Look at every aspect of your spending to figure out what is truly necessary and what isn’t.
And if you are looking for a budgeting spreadsheet to help with the process here is great list of free budget templates and spreadsheets so you can find just the right one to suit your needs.
Step 3 – Reduce Your Spending
Now that you are living within your means and tracking your spending, notice how every dollar you spend either takes you toward your goals or away from your goals.
You simply decide what priority you make certain goals – like financial freedom over current lifestyle. Remember, debt is caused by choosing the opposite. In fact, every day you are making literally 100s of these decisions that will make or break your financial future.
Your spending is a reflection of your values (once you become aware of your money). You want to align every dollar spent with your goals so that all spending moves you toward what you want most. You can’t have everything so you must decide what the highest priorities are.
The truth is you need far less than you think. The goal in this step is to get your spending down to your true “baseline” required spending so you can move away from lifestyle and toward financial security. The amount you save each month will determine how fast you can get out of debt so it is critically important.
Cut your spending ruthlessly. All excess and waste must be eliminated. Look at the big ticket items like housing and transportation first to make the biggest impact fast. Consider moving, getting rid of a car, using public transportation. Don’t assume any item is sacred no matter how entrenched, and at the same time don’t overlook any item no matter how inconsequential.
It all adds up.
Step 4 – Accountability To Supercharge Results
Tell the world about your goal to be debt free. Pick a date, form a plan, and tell those closest to you.
Your objective in this step is to literally build a box around yourself that doesn’t allow squirm room so that you enforce your new spending patterns until they become habit. Enroll a parent, spouse, coach, or friend as an accountability partner so you have someone to report your results to. Create the tracking system.
Heck, go whole-hog and tell all your friends and enroll them to support you. This might mean they don’t invite you to eat out or go shopping but that’s okay. They shouldn’t tempt you with high cost adventures. You could even email them monthly on your results, blog about it, or report it on Facebook. Seriously! Why not? Do you want the goal or not?
Accountability is a magically, powerful force for shaping human behavior so use it to your advantage. The whole reason we resist accountability is because we intuitively recognize its power.
The question is – do you want to get out of debt or not? Accountability gets results. Use it!
Step 5 – Get The Right Attitude
Don’t think in terms of sacrifice and all that you are giving up. Instead, think in terms of the peace-of-mind, freedom, and security you are heading toward. This is essential.
The cup is either half full or half empty. You choose the reality you live under. When you focus on where you are headed (peace of mind, security, and fulfillment) the reduced spending never feels like a sacrifice. In fact, it can be positively addicting because you are moving toward your financial goals – finally!
The Other Side Of The Coin – Increasing Income…
Now that you’ve reduced spending as far as possible the next strategy to getting out of debt is to look at all the ways you can increase income…
- Can you work overtime temporarily to get your financial situation under control?
- Is there seasonal, freelance, or part-time income you can add?
- What new job skills or education/certifications would increase your salary?
- Can you convert a hobby into income?
There are fundamentally two approaches to increasing income – short-term quick fixes and long-term permanent solutions.
The short-term quick fix is to increase the hours you work either through overtime, freelancing, or similar. This can be helpful to provide an immediate injection of cash but can lead to burnout over the long-term.
That’s why you also want to look into ways that permanently increase your income without having to work 24-7. This involves launching some type of business that begins as a sideline but can transition to full-time, or it involves gaining new job skills or certifications to increase salary in your current occupation (or possibly changing occupations).
A Few More Tips To Help Your Savings Grow Faster
Getting out of debt is a serious goal meriting serious action.
Below are a collection of additional tips in no particular order that can help you wage war on the debt monster…
- Debt results from a pattern of behavior (habitudes) so examine all patterns causing the problem and break them. This might involve changing friends or spending less time with the spendthrifts in your social circle. Any habit that results in unnecessary spending should be reconsidered.
- Don’t overlook radical measures that can make a huge difference. Rent is one of your biggest expenses. It may not be fun but moving in with friends or family, or living in your motorhome for a period of time can make a huge difference in your budget. Radical? Yes, but no more radical than putting up with the noose of debt strung around your neck.
- You absolutely must put a barrier between you and overspending. That means getting rid of your credit cards and other sources of easy credit. I said it before but I’m repeating it here because it is critically important. Cut them up or lock them away. You must live on less than you earn.
- Consider selling anything you don’t regularly use and apply the proceeds to your debt – fur coats, jewelry, a boat, motorhome, extra car. Craigslist, Ebay, and garage sales can convert an amazing amount of stuff into serious cash that can make a dent in your debt. Sure it is a short-term solution to a long-term problem, but it can also give you a jump-start while simplifying your life at the same time.
Putting it altogether, this gives you a four pronged attack for making forward progress on getting out of debt…
- Start by reducing spending to produce immediate results.
- Increase the spread between income and outflow by adding overtime or freelance work to provide a short-term income boost.
- Sell your stuff for a quick payoff.
- Add new job skills or start a business for long-term income growth.
- Rinse and repeat until you are out of debt.
While this sounds simple on the surface (because it is), I also want to acknowledge how difficult many people find these action steps to implement even though they intellectually understand the process. After all, you already know what you should be doing. The problem isn’t knowing what to do: the problem is getting it done. Again, that’s because the problem appears financial when it is really personal, and there is no simple solution to personal issues like discipline, determination, and prioritization.
I encourage you to seek out support systems and apply all accountability tools at your disposal. Unfortunately, there is no royal road to the destination. Your success or failure will depend on your commitment and clarity to getting out of debt.
You wield the power to get yourself in debt; therefore, you also have the power to get back out of debt. You just have to complete the steps.
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Once you create a positive spread between income and expenses the next step is applying the right debt payoff strategy to become debt free in the fastest way possible. There are two similar but distinct strategies that I will cover below…
Debt Snowball vs. Accelerated Debt Payoff
Start the debt payoff process by making a list of all your debts. You’ll find this information on the monthly statements your get in the mail.
Note the creditor’s name, interest rate, amount owed, and monthly payment. Enter all the information in this debt payoff calculator to help manage the process and estimate how long it will take you to get out of debt.
You can order your list of debts in two separate ways…
- Debt Snowball: Order the debts from smallest balance at the top to largest balance at the bottom. This gives you greater emotional satisfaction because you see results much faster. The small debts get eliminated quickly giving you immediate positive feedback and reinforcing discipline. This costs you a little more in interest than the alternative below but many consider it worth the price because the emotional satisfaction results in a higher probability of sticking with the process long enough to succeed.
- Accelerated Debt Payoff: The other alternative is to order your debts with highest interest rate at the top and lowest interest rate on the bottom. This is mathematically the best way resulting in the fastest, lowest cost payoff because it targets the highest interest rate debt first. The problem occurs if you have a large debt that is also high interest because it can feel like it takes forever to make any progress. This causes many people to give up.
There is no right/wrong answer to which debt ordering system is best. One is financially superior and the other is emotionally superior. The key is to decide what will work best for you so that you stick with the process long enough to succeed.
Next, enter the amount of income leftover each month that can be applied toward paying down debts in the box at the bottom of calculator. You get this number from the 5 step exercise above where you figured out how to spend less than you earn.
What this calculator will do for you is apply the minimum monthly payment on all debts except the top listed debt. That one gets the additional money from the step above to help pay it off as fast as possible.
Notice how the size of this additional payment determines how long it will take to get out of debt. I encourage you to play with different numbers and see how much difference it can make. It might be motivating to go back to the previous section and figure out how to increase your monthly savings so you get out of debt faster.
As the first debt is paid off you dedicate 100% of the money that went to that debt to the next one on the list. You repeat this process creating a snowball that concentrates an increasing amount of your total monthly payment to fewer and fewer debts until they are all paid off – in full. Yay!
Go ahead and punch your numbers into the calculator and give it a try. You might just be surprised how fast you can be debt free.
There are many ways to slip into debt. You might become underemployed, suffer a salary reduction, divorce, high medical bills, or simply lack good money management skills.
These life problems don’t necessarily translate into debt. Good money management skills combined with the following three rule system can save you from financial difficulty…
- Use debt only to purchase assets that increase in value or produce more income than expenses. Debt used this way leverages your balance sheet which can be a valuable wealth building strategy, but it can also increase your risk so be careful.
- Never use credit to increase consumption. If you don’t have the money in the bank to pay for lifestyle expenses then you can’t afford it.
- Credit cards should only be used for transaction convenience and should be paid in full each month.
These three simple rules will keep debt and credit problems from occurring regardless of life circumstances.
Credit is an expedient, short-term solution to life’s difficulties, but it is usually not the lowest cost or best solution in the long-term.
Once you have a problem the only way out is decisive action to solve the problem: it won’t solve itself. There is only one way to get back out of debt. You have to do the work. There is – unfortunately – no magic fix to debt and credit problems.
From the moment you commit to taking action until the day you are debt free will likely require many months or possibly years… so plan accordingly. Set yourself up to win.
- First you must stem the financial bleeding by reducing expenses. This involves tracking all expenses and aligning your spending with your values so no money is wasted. It may also require cutting up credit cards or freezing them so you eliminate easy access to credit. (Did I say that before?)
- Second, you must increase income to widen the gap between how much you spend and how much you earn. This can include both short-term strategies such as overtime and long term strategies like adding career skills or starting a business.
- Next, take the amount saved each month and dedicate it toward paying down debt using either the debt snowball or the accelerated debt payoff method.
The key point is to realize that debt and credit issues are a personal problem masquerading as a financial problem. This deceit is why so many people have trouble managing debt and credit. They look for financial solutions when the answer is personal – not financial.
Always remember the financial strategies for getting out of debt are simple to understand and implement. The personal obstacles that stand between you and debt freedom are far more complex and difficult to overcome.
This is the nature of the debt beast. That’s why slaying the debt dragon is the greatest path of personal growth for anyone who has the problem.
So commit to your growth and freedom! Make this year a time where you finally break the bonds of consumerism and debt slavery.
Get out of debt and begin the journey to financial freedom.
It may not be easy… but it certainly beats the alternative.
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