The vast majority of Americans owe money. That’s not necessarily a bad thing if debt gets you where you want or need to go. But if you lose control, debt is a trap.
Your debt is a problem if you cannot reasonably pay your expenses, save something for the future and still make progress toward paying off your debt.
It’s time to take steps when:
- You lose sleep over your debt or it’s never far from your thoughts.
- You fight with your spouse or partner over spending.
- You’re using one form of credit to pay another.
- You’re being called or sued by bill collectors.
- Your consumer debts — medical bills, credit card bills, loans — equal half or more of your income.
You can wait until you’re forced to make a panicked decision that has consequences for decades. Or you can start now and regain the upper hand on your own terms.
Here’s how to start:
1. Stop digging.
2. Save something before you pay anything.
3. Get a handle on what you owe.
4. Prioritize your debts.
5. Assess your resources.
6. Decide whether you can succeed.
7. Put your plan into action.
8. Plan for life after debt.
The first step in paying off debt is to do nothing. Literally. That means no new credit accounts — and no new expenditures on the accounts you already have.
If you depend on credit cards or other borrowing to pay your bills, you should be visiting a credit counseling agency or a bankruptcy attorney. No debt-payoff strategy works if you don’t have the means to complete it.
2. Save something first
As counterintuitive as it might seem, your first spare cash needs to go toward an emergency fund. Even $500 in the bank is enough to cover many car repairs or a medical copay.
Without something set aside for emergencies, every unexpected thing becomes an emergency where a credit card or other debt is the only option. That’s how many people get overwhelmed in the first place.
3. Get a handle on what you owe
Honestly assess your situation and formulate a plan before you send one extra dollar to a creditor.
List all your monthly expenses. Get out (or print out) every statement. You’ll want to record both the total amount owed and the monthly minimum payment.
If you have collections accounts or judgments, record those as well, even if you’re not making payments on them.
Next, get your free annual copy of your credit reports and compare the information there to the information you have just gathered. You may find debts you forgot or see debts you don’t really owe. Mistakes can and do happen, and the last thing you want is to pay more than you actually owe or to pay a bill that shouldn’t have been yours in the first place.
If there are errors on your credit reports, dispute them. You can dispute errors for free yourself; there is little benefit to hiring an outside company to do it for you.
4. Prioritize your debts
Separate your debts into piles:
- Consumer debt (this includes credit card debt, medical bills, payday loans and personal loans).
- Education debt (student loans).
- Auto loans.
- Mortgage debt.
Consumer debts should be your top priority to pay off. Only then you can consider settling your collection accounts. (Paying off collections doesn’t help your credit scores, and the money typically does not go the original creditor, but to the company that bought the debt for pennies on the dollar.) Student loans, auto loans and mortgages should be farther down the payoff list, because their interest rates are typically reasonable and often fixed.
5. Assess your resources
How much can you cut your spending? What unneeded possessions can you sell? Can you take a second job? (See “19 Ways to Find Fast Cash, More Savings.”)
Are there ways you can reduce your payments without endangering your credit?
- If you have medical bills, ask the provider if you qualify for charity or financial assistance programs that could reduce the total. If medical bills are in collections, ask the health care provider to take them back and work out a direct payment plan.
- Consider consolidating or refinancing your student loans to lower your monthly payments and free up more money to pay consumer debt.
- Compare options for consolidating your credit card and other debts at a lower rate.
6. Fight or flee: Decide whether you can succeed
Now comes the hard part: deciding whether you can get yourself out of this mess.
That is, can you address your problem with basic budgeting and a little financial footwork, or will you need to do something drastic?
Be sure to include savings in your plans. You may think every spare dollar should go to paying off debt, but failing to save for retirement will cost you more in the long run in lost 401(k) matches, tax breaks and compounding. If you have a workplace plan with a company match, contributing enough to get the full match is a no-brainer. Even if you don’t get a match, you should be saving something — say, 5% of your income — for your future in a 401(k) or IRA.
Can’t pay your bills, save something for retirement and still pay down your debt? Look into options for debt relief, such as bankruptcy or debt management, if either of these is true:
- You can’t repay your unsecured debt (credit cards, medical bills, personal loans) within five years even with drastic steps to reduce spending.
- The total of your unpaid unsecured debt equals half or more of your gross income.
Debt-relief programs can reduce your interest rate, reduce the total you owe, forgive late fees or wipe out debt altogether. Not everyone qualifies, and you’ll also lose access to new credit, either through the terms of the program or because your credit score takes a big hit.
On the other hand, if you can successfully pay down your debts, you’ll not only preserve your credit but be well-positioned, financially and psychologically, for a life with much less stress about money.
7. Put your plan into action
Begin by paying off your consumer debts (credit card debt, medical bills, payday loans and personal loans).
You can get out of debt quicker by paying off debts with the highest interest rates first (the avalanche strategy). But if you need a psychological boost to get started, pay off your smallest balance first (the snowball method).
Once one debt is paid off, direct your money to the next debt. Continue until all consumer debts are gone.
But paying off outstanding debts is only part of your task. You don’t want to wind up here again. That means having an actual budget — one that covers your current bills, pays off outstanding debts and stashes something away for retirement.
8. Next steps: Plan for life after debt
Once your consumer debts are history, you can better address your past and your future.
Your future: Step up your retirement contributions (shoot for at least 15% of your income) and increase your emergency fund to at least three months’ worth of expenses. It’s important to do this before tackling education, mortgage or auto debt. Money sent to those lenders doesn’t typically free up any credit or cash that you can use in case of emergency. If you lose your job, you may wish you had back the extra money you sent to Sallie Mae.
Your past: If you have collections you want to settle, research this tricky area and save up a lump sum equal to roughly half what you owe. You may be able to settle for less.
Then pick your next debt to tackle.
You may want to prioritize paying off private student loans, especially those with variable interest rates, because they have far fewer consumer protections if you face a financial setback than federal loans do. You typically don’t need to be in a rush to pay off federal student loans or mortgage debt, since these typically have lower interest rates and often are tax-deductible. In fact, mortgage rates are typically so low that you should pay off every other debt before you consider making extra home loan payments.
Image via iStock.