Beyond today’s high prices, consumers can be weighed down by too much debt, like a mortgage, an auto loan, student loans, or credit card balances. While not all debt is bad, especially if it’s on an appreciating asset like your home, too much debt is a risk that can lead to total financial failure.
A simple measure to determine whether you have too much debt is your debt-to-income ratio. To calculate your ratio, divide your monthly debt payments by your monthly gross income. A good debt-to-income ratio is less than 35%. If yours is higher, consider the following steps to lighten your debt load:
- Stop making new purchases: Ask any doctor; they will tell you the first thing you need to do in an emergency is stop the bleeding. It’s the same with money: your top priority is to stop spending. If you just can’t stop making new purchases, perhaps you need to rework your spending plan. Now, for most, budgeting sounds like a dreadful task. But we can make it easy through our Zero Sum Budgeting process.
- Organize your debts by their degree of risk: Low interest, appreciating asset-backed debts – like your home – are the least risky, while high interest, non-asset-backed debts – like your credit cards – are the riskiest. Organize them by their highest interest rate to lowest.
- EVERY month, always pay the minimum payments on each debt: First, focus on any debts you can finish off in two or three payments. Getting them out of the way will give you a feeling of early success and encourage you to keep going. Then, take payments you had been making towards the smallest debt you just paid off and allocate it towards the highest risk debt you have, in addition to the minimum payments you are already making. When that debt is paid off, allocate all those payments to the next debt, and so on.
- Rededicate yourself to building an emergency fund: Without an adequate emergency fund, credit card debt can balloon quickly when unexpected expenses come your way. Start with a goal of one month of living expenses then build up to three months over time. Make it harder to cheat by isolating your emergency fund at a different bank than your checking account.
Paying off debt isn’t easy, but it can be rewarding. Treat yourself as you reach milestones set along the way. This will provide you with the encouragement to keep going.
