The second step in my Debt Free in Seven Steps system involves composing a clear picture of the debts you want to get rid of, any assets you are willing to liquidate to make debt payments, and your monthly cash flow. You will want to have copies of your most recent credit card and loan statements, bank or investment statements, and a pay stub. A calculator and pen and paper will also be helpful. Ready?
Prioritize your debts
Begin by writing down the most recent balances of each of your debts. Next to that balance write the annual percentage rate (APR) you are paying on that account, and, if applicable, the minimum monthly payment. (Not sure where to find your APR? Look at the bottom of your credit card statements where it says “finance charges”. You should see a column that says “corresponding annual percentage rate”.
There are myriad ways to prioritize your debts. Some people recommend simply paying the balances with the highest interest rates first. This will save you the most money. Others, like Dave Ramsey, recommend starting with the smallest balance first, because paying that off first will provide some motivation to keep going. If either of these methods seems right for you, then go with it.
As an alternative, here’s a simple method that directs you to pay-off the card with the highest balance to minimum payment ratio first. It’s like the best of both worlds.
To calculate this ratio divide each account’s balance by the minimum payment. You will then pay the card with the highest ratio first. For example, with the following three credit cards you would want to dedicate additional money to pay off the MasterCard first, followed by the Discover and Visa cards. If two cards have very similar ratios, pay the card with the higher interest rate first.
Debt One $4,832 balance / $65 min. payment = 74.3
Debt Two: $2,191 balance / $40 min. payment = 54.7
Debt Three: $8,392 balance / $165 min. payment = 50.8
In this example, you would want to pay off debt one first, then debt two and debt three.
Apply existing assets to your debt
Now that you have your debts prioritized, take a look at your assets. If you have any cash in savings accounts or under the mattress, you should immediately consider using all of it to pay off some debt. Likewise, if you have valuable items that you aren’t using, sell them on eBay or hold a garage sale and put the cash towards your debt. You will want to save up money later, but right now the enormous interest rates you paying on your debt is far more devastating to your long-term finances than cashing out a savings account.
Calculate your budget
After you have put any cash-on-hand towards your debt, it’s time to determine your monthly expenses. To do this, check out our list of 10 great budgeting tools.
If you haven’t tracked your monthly spending before, estimate the best you can, leaving enough padding for unexpected expenses without inflating categories that are not necessary. For example, if you currently spend $50 a month on coffee, enter $30 and resolve to cut back in the future. In the debt payment fields, enter only the minimum payments. When you are done the calculator will tell you how much money you have left over each month after your minimum obligations are met.
This is the additional amount that you will send to your top priority debt each month, in addition to the existing minimum payment. Each month you will continue to make minimum payments to your other creditors. Once you begin your plan you will use what is called the snowball technique to decrease both the time it will take you to get out of debt and the overall interest you will pay.
Each month going forward, the minimum payments on your non-priority debts will go down, usually by a dollar or two. You will take these few dollars (trust me, they add up over time), and put them on top of the total amount you are sending to your top priority account. When that debt is paid you will shift the entire monthly payment to the next debt on your list, until each and everyone is paid off!
Go to Step Three
Next, you will learn how to create a finalized debt management and determine exactly how long it will take to get out of debt. Go to Step Three: Creating a Personal Debt Management Plan. Or, see all steps in my Debt Free in Seven Steps system.
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