The Step By Step Process To Get Out Of Debt
If you clicked on this link, I am guessing you want to rid yourself of debt. All debt. You are in the right spot. These steps are not easy. But they work. And boy do they work. These are the steps that got Jen and me out of debt. These are the steps that saved our financial lives.
Before we did these steps, we were living paycheck to paycheck. Not including our mortgage, our monthly loan payments totaled a little over $2,500. We had credit cards, furniture loans, car payments, an adoption loan, plus some other “zero” interest loans from various other stores. We didn’t have hardly any savings in the bank.
We obviously had tons of debt. But since we were investing every month, we thought we were doing just fine. We weren’t. When emergencies would come up (and they always did), we had no money to take care of them so we went deeper into debt. Because we had no money, little emergencies were always big emergencies. We were broke, much like the clients I work with and statistically speaking probably like you, too.
So what are these steps, you ask? Simple. Without any fanfare or delay, here they are:
- Create and then get on a budget
- Build your tiny emergency fund
- Start the debt snowball
- Build your real emergency fund
- Start investing and saving for your kid’s college
- Pay off your house
Wait! Okay, you see the steps above and you are racing to get started. Well, hold on just a second and let’s get a better understanding of what we do for each step.
Create and then get on a budget
To get started, you absolutely MUST BE ON A BUDGET! Here is the problem: most people do not know how to do a proper budget. A proper budget is not just tracking your expenses. There is more to creating a proper budget than that, but trust me when I say it is not as hard as you think. You do not need to be a math major or a calculus whiz to do one. All you need is a pencil, some paper, a calculator and the last three months of your bank and credit card statements. I can walk you through it. Go ahead and get those items now. I will wait.
Okay, the first part of this step is to write your total monthly income on the top, right-hand side of the piece of paper. Next, we are going to start writing our expense description on the left side and the dollar amount directly below your income number. Start off with the mortgage or rent. Then put down your utility bill, followed by car payments, loans and any other expenses that are consistent. Once you have all of the “static” monthly payments down, I want you to look at the last three months of credit card and bank statements. Add up all of the money you have spent on food, not including any restaurants or dining out. Once you have added those numbers up from the last three months, divide it by three to get a monthly average. That is going to be your monthly food budget so put this amount on the paper. Notice how the dining out and restaurant expenses are not included? Yeah, because as of now, you will not be eating out. Eating out is a huge waste of money. Don’t believe me? Add up your restaurant expenses from the last three months. I bet you will be shocked…
Below the monthly food, let’s put an amount for gasoline and/or transportation. Add up all of your gas expenses from the last three months divide that number by three. That is your monthly gasoline budget. Put that on the paper. Do this for all of the other expenses that I haven’t covered, if needed. If you are in debt, you will not have a Starbucks category. You will not have a “going out” category. You will eliminate all extra expenses. Remember, the goal here is to get out of debt so you have to have as much extra money as possible to pay off your debt! The more serious you are about cutting extra spending, the quicker you will get out of debt.
Okay. So now you have a piece of paper with a bunch of numbers and expenses on it. Now what? It should be obvious that you need to take your income at the top of the sheet and start subtracting each expense below it. When you are finished, put that number at the very bottom of the paper and circle it. If it is a positive number, that is the extra money from your paycheck that can go towards your debt. If it is a negative number, you’ve got a bit of a problem in need of fixing. Most of the time and based on my experience, your budget is wrong. You included extra things that you think you must have. I have had people tell me that their children needed those flute lessons. They needed that vacation. They needed those $5 coffees. They needed to go out on Friday nights with their friends. No, they didn’t and you don’t either. If you think you need those things and cannot do without, then you are a hopeless cause and you will forever be in debt. You will always be financially obese. You will grow older and wish you could retire, but can’t because you have no money. You are better than that. I know you are. I told you this won’t be easy.
What if you trimmed all of the fat from your budget and you are still staring at a negative number? Well, if you are absolutely certain there is no more fat to trim, then you have some options. You can either start selling your stuff or go find an additional job. You may have to do both. I know it sucks, but you may need to sell that expensive car. You may need to downsize your home. Jen and I ended up downsizing our house. Our rent went from $1,900 to $1,400 which added an extra $500 a month towards our debt. But you have to be serious about getting out of debt. You have to be serious about becoming financially fit. You have to WANT to become wealthy.
For the rest of you with positive numbers, read those last two paragraphs again. Even with a positive number, an extra job along with selling a bunch of stuff will easily knock a few months off your journey.
You now have a monthly budget completed. Here we go. This is the “fun” part in which everybody dislikes. The amounts you have listed under your food category is a contract agreement that in no way, shape or form will you spend MORE than the amount listed. If you blow all of your monthly food money in a week, then you are living off crackers and peanut butter for the rest of the month. If you blow through your gas budget, you are walking or riding your bike. Yep. You have got to hold yourself accountable. You must treat your budget like a contract that cannot be broken. It is time to grow up and be responsible.
Every month, you will do your budget. It will take about three months before your budget starts flowing smoothly. And each month you do your budget, the easier it will become. Jen and I have been budgeting every month for four years and it now takes us less than five minutes when we sit down.
That is the budget part of the process. To keep track of the money in each category, we will use what is called, “The Envelope System.” This system is one of the easiest budgeting systems you will ever use. Basically, by using the envelope system you get a bunch of envelopes, label them under each category (food, gas, clothes, etc.) and at the beginning of the month, you put the exact amount of cash from your paycheck into each envelope. When you buy food at the grocery store, you take cash out of the “Food” envelope. When you go buy gas for your car, you take cash out of the “Gas” envelope.
The only drawback to this system is that you have to carry large wads of cash around with you which can get lost or stolen. If your spouse is filling his gas tank, he has to find you to get cash from the “Gas” envelope. It can be a hassle. That’s why I created Budget Monster. It is a virtual envelope budgeting system that is the exact same concept, but instead of carrying around envelopes full of cash, you keep your money in the bank and track your envelopes through a simple text message.
Build your tiny emergency fund
Now that your budget is setup, you have to build a tiny emergency fund. Right now, you do not need a huge amount of money in the bank. You need just enough to get you through any small emergency you might encounter.
Right now, “tiny” houses are all the rage. These tiny houses have all the amenities of regular size houses, but they are ultra efficient. That’s exactly what this emergency fund is. It is designed to be a highly efficient fund that can handle the small stuff. For most people, somewhere around $1,000 is plenty. You will have to determine if you need more or less. If you decide you need more, do not go more than $2,000. The amount in your tiny emergency fund should scare you a bit. It should scare you enough to get you out of debt quicker so that you can build that emergency fund up to a fully funded emergency fund.
If you don’t have $1,000 in the bank, then every month you will take your extra money left over from your budget to build up to that amount. If you have more than what is required for your tiny emergency fund, guess what? Yep, you put it towards your debt. If you have $40,000 in the bank and have $70,000 in debt, you will be writing a check for $39,000 towards your debt, leaving you with $1,000. Ouch. Extreme times call for extreme measures. This is a war and the consequences could be your financial future.
Start Your Debt Snowball
With your tiny emergency fund in place, you can now start putting all of the extra money from your budget towards your debt. There are lots of techniques on how to do this. There is the “Ladder” method that has you pay off the high-interest rate loans first, but in my experience, that is not the answer. You are going to have to take my word on this, but I believe the best method is called “The Debt Snowball.” This method is an extremely powerful technique that pays your debt down as fast as possible while keeping you motivated.
To get started, list all of your debts except for your house. Every single debt must be listed. Student loans, car payments, personal loans- if you owe money, it is listed. Make sure you are writing down the remaining dollar amount on each loan. Now, arrange them from the smallest amount owed to the largest amount owed. The debt snowball method has you pay the minimum payments on each of your loans except for the smallest one. On the smallest loan, you throw every extra penny from your budget towards this debt until it is paid off. Once it is paid off, you move on to the next debt. Except, this time you have the extra money from your budget in addition to the minimum payment of the debt you just paid off to apply towards your next biggest debt. Each debt that you pay off builds on the amount of extra money you have in your budget just like a snowball. Each time the snowball rolls over as it comes down the mountain it picks up more snow, becoming larger and larger. Eventually, the snowball becomes an unstoppable force. That’s what happens to each debt you pay off. Each debt’s minimum payment builds towards the next payment and by the time you are at your last debt it will be one huge monthly payment.
Build Your Real Emergency Fund
With all of your debt paid off, I am sure you are feeling quite good. Yes, you have accomplished a lot. You are now ahead of 90% of the American population. But you are walking a dangerous line right now. You might be tempted to go treat yourself with a big expensive item or even, I gasp to think about it, go get another loan. Yikes. Do not do it. You are not out of the woods yet.
The next step you must do is build your real emergency fund. Most financial advisors recommend an emergency fund that can cover at least three to six months of expenses and I am going to tell you no different. Why three to six months of expenses? What if you lose your job? It might take a few months to find another so in the meantime you will need a buffer because bills will still need to be paid.
How do you calculate your three to month expense amount? Easy. Your budget is already made right now. Add up your total expenses for the month and multiply it by six. That is how much you need for a six-month emergency fund. Remember, this is three to six months of EXPENSES. Not income. Do you need a three-month emergency fund or a six-month emergency fund? The answer is pretty simple here. I would base it all on how “secure” your job is. Job security is not you saying, “Well, I am pretty important so there is no way they would fire me!” Raaaawng! Government jobs with a steady paycheck, teaching jobs with tenure, military, police or fire fighters- all have pretty secure jobs. Jobs that might not be as secure are ones with flexible paychecks, a business you just started, or a job you just started. This could even be a sales job where your paycheck varies from month to month. It is up to you to decide how much you need in this emergency fund. And if you can’t decide whether to do a three or a six-month fund, then go conservative and build a six-month fund.
Where do you stick this emergency fund? I am glad you asked. Most financial advisors recommend a money market account where it will earn a little bit more interest, but you can still get to it easily. As long as you can get to it easily, it really doesn’t matter where you put it. I am not telling you to stuff it into your mattress. It needs to be, at the very least, in a savings account. Read this part carefully: the goal of this fund is not to earn interest. The goal of this fund is to be able to get to it easily in case of an emergency, with no hassle or penalty. Do not put it in a CD or a mutual fund. There are penalties for early withdrawal from a CD. Mutual funds could take a day or two before you get your money. A money market where you can write checks from or a savings account is perfect. A money market would give you a little better interest than a savings account, but that isn’t the goal. Jen and I have our emergency fund in its own savings account at our bank. It is its own entity. We do not put vacation savings or Christmas savings in there. This fund is strictly for holding our emergency fund. In fact, we have it hidden on our online profile so we don’t even see it when we log in to our account.
When can you use this money? This should be fairly obvious, but I have to devote at least a paragraph because I get a lot of questions regarding this and I know that some of you might get tempted with a lump of money in an account… This money is for emergencies only. Your emergencies. When your transmission goes out and needs repair- that is an emergency. When the wind blows your roof off and you have to pay for a deductible or replacement- that is an emergency. When you lose your job and need to put food on the table and keep the lights on while you look for another job- that is an emergency. When you decide to buy another car- that is NOT an emergency. When a family member calls you up asking to borrow money- that is NOT an emergency. Your emergency fund is only for emergencies. If you deplete your emergency fund on something other than an emergency and an emergency happens, you will have no money to pay for it. Do not fall into the temptation trap. If you think you could be tempted to spend your emergency fund, put it in a completely different bank. That way, it is still easy to get to, but it is out of sight and therefore out of mind.
Start investing and saving for your kid’s college
Congrats! You are debt free (except your house, of course) and have an emergency fund built— momentum is definitely on your side. You are winning with money. Now we can start taking a look at your future. We do this by investing. I know you are excited about this step. I know you have a lot of momentum and you are feeling like you want to toss as much money towards investments as possible. I love your enthusiasm, but hang on. This is a step that really doesn’t need a whole heck of a lot of money tossed into every month. If you were to put all the money that you put towards your debt into monthly investments, you would not have anything left over for your regular savings. You would not be able to buy new couches, cars, go on vacation, etc. (i.e. have fun).
So we have to control our contributions and let the power of time and compounding interest work for us. Let’s take a look at some numbers. Let’s pretend that 20 years ago I decided to put $166 a month into a good mutual fund. And over the past 20 years, this mutual fund has grown at the average rate of the stock market since its inception, at about 11-12%. How much money would I have now? I would be sitting on a little over $140,000. Okay- so that isn’t all that much right? Well, stay with me. If I continued to contribute that same $166 a month for the next 10 years I would have a little over $440,000. Now we are talking, right? Okay- let’s go another 10 years at the same investment rate. I would have about $1.2 million. So as a 20-year-old, if I invested $166 a month for my entire working life, I would have $1.2 million. And if I kept those same investments starting at 20 and stopping at age 65, I would have $2.1 million! Of that $2.1 million, I only contributed about $90,000 over the course of my working life. That is not a lot at all. That is the power of compounding interest. After 20 years, I only had about $140,000. But in another 10 years, my money almost quadrupled. And then in another 10 years, it did quadruple and I became a millionaire. And in another 5 years, my money doubled. That’s pretty exciting stuff, right? And this example doesn’t take into account that I might be getting a raise in those 45 years which allows me to invest even more every month.
So what if you don’t have the next 45 years to build your fortune? It’s fine. But you may have to work harder. You may have to invest a little more every month to catch up. But it is never too late to start. If you are 35 and can invest $1,000 a month for the next 30 years, you would be sitting on about $2.6 million. If you are 45 and can invest $1,000 a month for the next 20 years, you would have about $900,000. That is still not chump change. The point is you can do it. You can take the steps now to ensure you will not be relying on your children or worse, the government, to take care of you in your retirement years.
How much of your paycheck should you invest every month? Again, most financial advisors recommend investing 15-20% of your pre-tax monthly income every month. Whatever your monthly income is, multiply it by 0.15 and that is your monthly investment. Even if you have a matching contribution plan from your employer, you still invest 15-20%. The matching contribution is just icing on the cake. Get with a reputable financial planner to get started.
In this step we are also saving for our kid’s college. Some parents don’t like the idea of paying for their kid’s college. The assumption nowadays is that the kids can get a loan or they can figure it out. I am not here to tell you what to do. But I can tell you what we do in our house. We have a plan to set our kids up for the greatest success possible. What if we could use the power of compounding interest to build our kid’s college fund with very little effort on our part? What if because of this little effort, our kids go to college and graduate debt free and continue living life debt free? What if I invested only $166 a month for my child’s first 18 years of life? How much would she have for college? About $111,000. That is a good chunk of change to go to college. That is more than enough, if done correctly. Here is a news alert that might shock a lot of you: your kids don’t need to go to an expensive school. Your child could go to a community college for the first two years and transfer to a state university for the last two years for about half that amount. If your child is picking an expensive, out of state university to attend then you are going to have to step in and be that dreaded “P” word. A parent. There is absolutely no reason to pay the inflated out of state tuition because that’s where your kid wants to go, or even worse, because that’s the school with an awesome football team. Ugh.
If your kid wanted to go to an in-state university for all four years, you could also pay for that with that chunk of change. Your child may have to get a job to help pay for it and/or get some scholarships. Either way, it is up to you on how much or how little you want to help. But again, in my family, we are devoted to helping as much as we possibly can. If a small monthly contribution can get my kids through college and starting life debt free, guess what I just did? I changed the financial vector for generations to come. If my kids graduate college debt free, get a job and start investing, then they will be financially stable their entire lives (not to mention the inheritance they get from us) which stabilizes their children’s financial future, and their children’s children financial future. That makes me smile just thinking about it.
Pay off the house
A confession: as of this writing, Jen and I do not have the house paid off. But we are working hard to get it paid off. Imagine not having a house payment! Imagine if you could stick your house payment into a mutual fund that pays you instead of giving that amount to the bank every month? That kind of thinking motivates me. Another truth here- a lot of people are afraid of this step. They think it is impossible to pay the house off early and what little extra that can be put towards the house won’t amount to much. Raaaawng! Take a look at the breakdown of your monthly payment. Look at how much goes towards interest and how much goes toward the principal. If you have a relatively new mortgage, the breakdown could be that just a couple hundred (or less) of your payment goes towards the principal (the amount you owe). Whatever the principal amount is, let’s just say it is $150, if you double that principal amount on your next payment you just knocked one month of payments off the life of your loan. If you did that for a year, you just knocked a year off the life of the loan. What if you could put more towards the house every month? Maybe $300? Then you just knocked an extra two months off the life of the loan in one fell swoop, well in addition to the month you just paid in the regular payment.
If you doubled the principal amount every month, you could pay a 30-year mortgage in 15 years. You could pay a 15-year mortgage in 7.5 years. That’s pretty exciting. What if you could pay off your house in 10 years? How old will you be with a paid for house? What if you could pay yourself a house payment over the next 15 years? 20 years? 30 years? What if you designated that money towards your retirement dream home? When it is time to retire you could sell your paid for house and that amount in addition to the dream house fund could buy quite the property, right? And you would buy your dream home with CASH. Yeah, baby.
This last step is the best part. This is the part that Jen and I look forward to. We want to celebrate living completely debt free. We want a paid for house. We want to know what it is like to say that we OWN our house. Even with a mortgage, we can’t legally say we own our house. The bank owns it. If you have a mortgage, it is like being in a rent to own contract with the bank. When the payments all total up to the amount of the house, plus interest, we would then own the house. Don’t believe that? Do me a favor and stop making the payments on your house for a few months. What would happen? Eventually, with no payments, the bank would come and kick you out of their house. The bank would take “your” house away from you and sell it. You would be homeless. So you don’t own it until you have no payments.
But what if the housing market crashes? So what? If the value of your home drops, it doesn’t matter whether you have payments on it or not. The only difference is that you won’t care if it is paid for. If you own it free and clear and the value drops by half, well you still keep paying yourself your own house payment, still keep investing. If you had gobs and gobs of money in your dream house fund and the housing market crashed, guess what? Your dream house is now on a big clearance sale! Yeah, baby. If you still owe money on your house and the housing market crashes, then you keep making the payments as usual.
One Last Thing
There is one last item of discussion I would like to touch upon. Giving. As a Christian family, Jen and I feel it very important to tithe. If you are an atheist, you can still give and a good starting point is 10%. There is nothing more fulfilling than knowing that we are giving to something greater than ourselves. We love giving and we love helping. Jen and I track our giving as much as we track our spending. We don’t track for bragging rights or for tax purposes (although that is a small reason we track). Our main reason for tracking our yearly giving is to have a benchmark to beat for the following year. In the past four years, we have given more money than the subsequent years. Our goal is to have started off giving away 10% and living off 90% and eventually get to the point where we give 90% and live off 10% of our income. That’s a pretty lofty goal. It’s going to take a lifetime to get there, but it will happen. And the best part is that even when we reach that goal it won’t even put a dent into the inheritance for the kids. Besides, if we raise the kids into financially sound adults, they won’t need any inheritance from us.
If you haven’t given at least 10% before, I think you should try it. If you are a Christian, did you know that this is the only time in the bible that God wants you to test Him? He says to test Him in this area and see how much more He will give you back. Of course, I am paraphrasing. If you are not religious, that is fine. Do it for whatever reason you can muster. Karma. Do it for a good feeling. See what good things happen in your life when you give. Trust me on this. Or better yet, test me.