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Managing Debt Introduction


Debt, although it is the bane of many people's existence, is increasingly becoming the American way. The average American spends $1.22 for every dollar earned. That is right! On average, we spend more than we make. This behavior inevitably leads to debt. People who spend more than they earn finance the difference that they haven't earned with credit cards, home equity lines of credit, and personal loans. That means that they are in debt; they owe the bank and other financial institutions money that will have to be paid back at some point. Spending more than you make is the financial equivalent of taking one step forward and two steps back because when you finance debt you have to pay interest (fees) as well as paying back principal (the amount you have borrowed). So, you end up owing more than what you borrowed originally. You should work to avoid getting into debt when you can except in a few cases such as taking out a mortgage on a home to live in, and and financing your education. Mortgages and educational loans are examples of "good debt", but most debt is debt you don't want to have.

If your debt-to-income ratio (DTI) is 30% or more, you are in financial distress (whether you know it or not) and it is time to take action. Avoiding your money issues will only make things worse. You have to face down your fears in order to change your situation.

The first thing to do when trying to get out of debt is to close any leaks you have in your wallet. Take an honest look at your expenses and see where your money is going. Stop using credit cards (put them away in a sealed envelope and do not use them anymore). Eliminate any expenses from your routine that are not strictly necessary. Unnecessary expenses, like cable television, eating out at restaurants, and drinking at happy hour (and drinking in general) are luxuries you temporarily cannot afford. Limit your spending to the basic necessities you have to engage in in order to survive. Spend money on food (from the grocery store, not from restaurants), and on paying the mortgage or rent, utilities and key insurance bills. If there is any money left over after these key bills are paid, apply that extra money to paying down your debt.

Adjust your lifestyle to live within your means. If you have possessions that you owe money on, such as an expensive financed car or boat, you should consider selling those possessions off and then downgrading to something more affordable. If your rent/mortgage is a large percentage of your income (more than 35% - this is not at all uncommon in our society, where DTIs can run to 50% and 60%), look into selling your home for a less expensive one or moving into a cheaper apartment. The same is true about your transportation. Sell that nice car and get an economy car instead. Although making these changes will be emotionally difficult it is important to understand that working solely to make rent/mortgage or a car payment is to be a servant of the bank that owns your loans. You are working to make the bank profitable, and not yourself. You must refuse to be beholden to your possessions.

In addition to downgrading your possessions, you will also want to liquidate any non-essential assets. That is, sell valuable possessions that you do not really need to live decently (both now and in the future) in order to generate some cash with which to pay down your debt. This does not mean that you should liquidate your savings, retirement assets or that you should borrow against your 401(k). Retirement accounts are essential and irreplaceable assets that you will need in the future. Additionally, depending on the type of account, there may be tax consequences and penalties for withdrawing from them.

Once you have made these lifestyle changes, you should develop a strategy for paying off debt. There are smart ways and not so smart ways to pay off debt. The quickest way to pay off debt is to make minimum payments on all but one account. This account should the one charging the highest interest rate. On this one account you will pay as much as you can afford. You will continue to do this each month until that account has a zero balance. After you pay off this account, you will repeat the process with the account that is charging the next highest interest rate and so on and so forth. The process is called debt acceleration, and it can save you hundreds if not thousands of dollars in interest. Debt acceleration is strongly recommended in favor of bankruptcy.