10 Feb 2010

4 Steps to Tackle Debt Successfully

It’s certainly easy enough to get yourself into debt, but when it comes to becoming debt free most people struggle for their entire lives without ever fully experiencing a debt free existence.
There are many ways to deal with debt but following four steps I found most useful for us, so I wanted to share them with you.

1. Identify Your Debt
Listing ALL your debt might feel quite unpleasant but sometimes eyeopening. There are several ways how you can pay off your debt quicker but all of them would require you to know exactly how many holes you need to plug first.
List your debt considering following categories: mortgage, bank overdraft, student loans, store cards, consumer loans (paying off furniture, car, etc.), credit cards, friends and family, tax (for self-employed)... Anything else?

2. Decide How Much You Can Spare

Some of your loans will have a set amount of money and a predetermined length of repayment, others would operate on a minimum payment basis. Do your sums! I have listed all our loans in a table where I could note against each loan monthly minimum payment, loan term, interest rate, overall outstanding balance.
You are looking to establish the minimum you must pay towards all your debt (so if you are currently overpaying on your credit cards you still need to write down the minimum payment they would accept).

Now look at your income and spending, identify how much more than the minimum payment amount you can contribute towards repaying your debt.

We used this Statement of Affairs calculator to establish our monthly outgoings as well as to calculate our net worth and the amount of money we could dedicate to debt repayment.

3. Prioritise Your Goals

Now you need to decide how you want to repay your loans and other debt. Here is a quick overview of the different approaches to debt repayment currently "on offer".

With the debt avalanche method, you pay off your debts by interest rate, tackling the highest rates first. The avalanche is the mathematically superior approach because you will pay less interest and can get out of debt quicker.

Debt snowball approach - here you order your debts by size and pay off the smallest first. The theory goes that quick wins will keep you motivated. You throw as much money as possible at your chosen debt while paying the minimums on the rest. When the targeted debt is gone, you apply the same payment plus the minimum to the next debt, and so on. The amount you apply to your targeted debt grows as you pay off each bill, and you pack together those little victories to make a big dent in what you owe.

The debt snowflake, can supplement the other strategies. When you snowflake, you look for little ways to trim your expenses. Brought lunch with you from home today? If you were "snowflaking," you would apply the £10 you'd saved on lunch directly to your debts, either the same day or at the end of the week (hopefully combined with other little snowflakes of savings).

We use a mix of an avalanche and a snowball. Because we got some money back from one of our loans we had money spare to repay the overdraft on one of the bank accounts which was also the most expensive debt on the list.
Now we are repaying two loans and two credit cards. One of the credit cards receives only a minimum payment and the other credit card gets all extra money that we have allocated for our debt repayment.

I used the snowball calculator to create our payment schedule. This particular tool allows for change in payment terms (in particular in interest rates). This is very useful if you have cards with introductory low/zero interest rate offers that expire after a while. The tool puts loans with 0% at the top of your list allowing you to repay them while introductory offer lasts.

4. Automate Your Payment

We have direct debits coming out of our joint account so that 90% of our payments are automated. When we recently moved some of our debt to a 0% credit card the small print on this new card (Virgin card) said that the moment we miss a payment remaining credit on our card will be subject to 18.6% interest charged until all the money is paid off.
At the same time Virgin does make it quite complicated if you want set up a direct debit and the only option they offer you to set up over the phone is paying the minimum amount. If you want to pay any more than that it get very confusing and involves paperwork.

It makes me wonder how may people missed their first payment just because the direct debit didn't work and now facing interest charges on their transferred loans ...

By paying off one debt, re-prioritising other payments and increasing overall amount available for repayment by only 10%, we cut the time we will be paying off by nearly two years!

If everything goes to plan we will be debt free by June 2012!

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