Breaking free from debt
May 28th, 2009 by Bill
As Americans, most of us have fallen into the credit trap and many of us are still there. Whether it was because we were unaware of the hole we were digging or simply couldn’t resist the instant gratification and didn’t care about the hole, many of us now find ourselves wallowing in debt with no obious way out.
Yet, there must be a way to break free from debt…and yes, there is:
Stop using credit
First of all, stop using your credit cards. If you are afraid to cut them up, at least take them out of your wallet and put them in the safe or filing cabinet. You can’t get out of debt if you continue to consume credit. Even if you intend to pay it off at the end of the month, don’t use them. Pay in cash or check whenever possible. You can use debit cards, however be wary of the trap where they can “become” as “credit”.
Fix your cash flow
Secondly, if you are having trouble making the payments, contact your credit card company or bank and discuss the issue with them. Most of them would rather work out terms than have you default on your balances.
Clear your credit balances
Okay, so we’ve stopped increasing our debt load, now how do we deal with our existing debt load and how long will it take? Most of us grudgingly make the minimum or stated payment on our credit obligations every month. The solution is actually surprisingly simple and mathematical. What??? You don’t do math…? Well, these math equations are very simple and we’ll lay it out for you step by step. Here is a high level view of the steps that we must take:
- Itemize your debt. Include the name, balance, and minimum payment
- Calculate your current positions
- Calculate the best payoff plan
- Expedite it!
- Put it to work!
Step 1: Itemize your debt
| Creditor | Balance | Payment | ||||
|---|---|---|---|---|---|---|
| Car 1 | $15,000.00 | $250.00 | ||||
| Car 2 | $5,104.00 | $125.00 | ||||
| Mortgage | $89,200.00 | $645.00 | ||||
| Equity line | $39,000.00 | $390.00 | ||||
| Visa 1 | $1,004.00 | $25.00 | ||||
| Visa 2 | $7,520.00 | $85.00 | ||||
| Total | $156,828.00 | $1,520.00 |
Wow! Look at all that debt. And that monthly payment total is a killer! I feel faint, is there any hope for me? Well, that’s where the magic comes in. You’ll notice we left a few extra columns in this spreadsheet, that’s where we go to work with step 2 where we calculate our current positions.
Step 2: Calculate our current position
Now it’s time to see how long it will take to payoff each credit obligation based on our current payment schedule. For each obligation, divide your total balance by your payment to get a rough payoff period, which we will call Plan B where B stands for “BAD”. For this exercise, we won’t consider interest rates, although if you have an extraordinarily high rate, you may want to consider re-financing. If you take the largest number in the Plan B column, ignore interest and make all your payments as scheduled, this is the number of months until you are debt free. In our example, this is 138.3 months or 11.5 years. That’s quite a while for a debt payoff program.
| Creditor | Balance | Payment | Plan B | |||
|---|---|---|---|---|---|---|
| Car 1 | $15,000.00 | $250.00 | 60 | |||
| Car 2 | $5,104.00 | $125.00 | 40.8 | |||
| Mortgage | $89,200.00 | $645.00 | 138.3 | |||
| Equity line | $39,000.00 | $390.00 | 100 | |||
| Visa 1 | $1,004.00 | $25.00 | 40.2 | |||
| Visa 2 | $7,520.00 | $85.00 | 88.5 | |||
| Total | $156,828.00 | $1,520.00 | 138.3 |
Step 3: Calculate the best payoff plan
Now, here is the sneaky part: We are going to determine what order we are going to pay off our credit obligations. This has nothing to do with balance or payment, but on the number we just computed which is the number of months to payoff on the normal program. Time to add our next column to the spreadsheet, we’ll call this “Priority”. Start by finding the lowest number in the “Plan B” column and number it as 1, find the next lowest and number it as 2, and so on. If you want to, you can even re-order your list in order of priority which is what we have done below.
| Creditor | Balance | Payment | Plan B | Priority | ||
|---|---|---|---|---|---|---|
| Visa 1 | $1,004.00 | $25.00 | 40.2 | 1 | ||
| Car 2 | $5,104.00 | $125.00 | 40.8 | 2 | ||
| Car 1 | $15,000.00 | $250.00 | 60 | 3 | ||
| Visa 2 | $7,520.00 | $85.00 | 88.5 | 4 | ||
| Equity line | $39,000.00 | $390.00 | 100 | 5 | ||
| Mortgage | $89,200.00 | $645.00 | 138.3 | 6 | ||
| Total | $156,828.00 | $1,520.00 | 138.3 |
Now what we want to do is, pay the minimum payment on the loans except the one with the lowest priority. Let’s figure out what this looks like before we determine how to expedite this plan. What we are going to do is to add three more columns, an adjusted balance which represents the new debt balance when the new payment amount kicks in, a new payment amount called Pmt G where “G” means Good and the new months to pay off called Plan G. The adjusted balance will start out the same, however for later obligations consider that you will have been paying the minimum payment at that point and the balance should be reduced by the minimum payment multiplied by the number of months it took to payoff the previous obligations. Once again, we’re not factoring in interest here, so there is a bit of variability involved. The new payment will start off the same, but as we pay off each obligation, we will take the amount that we were paying there and apply it to the obligation with the next lowest priority. We’ll then take that new payment, divide that into the balance to come up with an adjusted months to payoff and place this in “Plan G”.
Lets work through a couple of examples. Since our first debt doesn’t really change because nothing has happened yet, we’ll begin with the second debt which is “Car 2″. Our increased payment for “Car 2″ won’t happen until we’ve paid off “Visa 1″, which will take 40.2 or actually 41 months. During that period of time, we will have made 41 payments of $125.00 on “Car 2″, totalling to $5125, which actually results in “Car 2″ getting paid off at the same time as “Visa 1″. So our beginning balance on “Car 2″ is effectively 0 and it will take 0 more months to pay off.
Our next debt to work on becomes “Car 1″, using the same calculation as above we see that we’ve made 41 payments of $250.00 for a total of $10,250. This reduces our previous balance of $15,000 to $4750 which becomes our adjusted balance. We compute our new payment for “Car 1″ which is the existing payment of $250.00 + the previous payments for “Car 2″ and “Visa 1″ for a total of $400.00. When we take our new payment and divide it into our adjusted balance of $4750.00 we see that it will take 11.9 or 12 months to pay off this obligation.
Let’s work one more example using “Visa 2″. By the time we get to “Visa 2″, 53 months will have elapsed ( 41 + 12 ) where we have been making the minimum payment of $85.00 for a total of $4505.00. This reduces our previous balance of $7,520.00 to $3015.00 which becomes our adjusted balance. We compute our new payment for “Visa 2″ which is the existing payment of $85.00 + the previous payments for “Car 1″, “Car 2″, and “Visa 1″ for a total of $485.00. We divide our adjusted balance of $3015.00 by the new payment of $485.00 to see that it will take 7 months to pay off.
Add up the total months in the last column and this is the new total months until you are debt free! In our case, 104 months or approximately 8.5 years. Still a long time, however we’re getting closer.
| Creditor | Balance | Payment | Plan B | Priority | Adj Bal | Pmt G | Plan G |
|---|---|---|---|---|---|---|---|
| Visa 1 | $1,004.00 | $25.00 | 40.2 | 1 | $1,004.00 | $25.00 | 40.2 |
| Car 2 | $5,104.00 | $125.00 | 40.8 | 2 | $0.00 | $0.00 | paid off |
| Car 1 | $15,000.00 | $250.00 | 60 | 3 | $4750.00 | $400.00 | 11.9 |
| Visa 2 | $7,520.00 | $85.00 | 88.5 | 4 | $3015.00 | $485.00 | 6.2 |
| Equity line | $39,000.00 | $390.00 | 100 | 5 | $15,600 | $875.00 | 17.8 |
| Mortgage | $89,200.00 | $645.00 | 138.3 | 6 | $38,890.00 | $1520.00 | 25.5 |
| Total | $156,828.00 | $1,520.00 | 138.3 | 104 |
Step 4: Expedite it!
Notice that our total monthly cash flow has not changed, we’ve accomplished this simply by rearranging how we pay off our debt. Now let’s consider how we might expedite this, which as you may have guessed, involves adding more money into the equation. How much extra can you afford per month? Most of us could manage to throw another $50.00 or $100.00 per month at something that has almost immediate returns. Let’s say $100.00 for this example, the cost of two nights of eating out at a restaurant for two people. We factor this $100.00 right in at the start, let’s see what type of change this makes in our payoff program.
| Creditor | Balance | Payment | Plan B | Priority | Adj Bal | Pmt G | Plan G |
|---|---|---|---|---|---|---|---|
| Visa 1 | $1,004.00 | $25.00 | 40.2 | 1 | adj | $125.00 | 8.0 |
| Car 2 | $5,104.00 | $125.00 | 40.8 | 2 | $4104.00 | $250.00 | 16.4 |
| Car 1 | $15,000.00 | $250.00 | 60 | 3 | $8750.00 | $500.00 | 17.5 |
| Visa 2 | $7,520.00 | $85.00 | 88.5 | 4 | $3865.00 | $585.00 | 6.6 |
| Equity line | $39,000.00 | $390.00 | 100 | 5 | $19,500 | $975.00 | 20 |
| Mortgage | $89,200.00 | $645.00 | 138.3 | 6 | $44,050.00 | $1620.00 | 27.1 |
| Total | $156,828.00 | $1,520.00 | 138.3 | 98 |
By adding $100.00 to the equation, we dropped the time required to payoff our debt by 6 months. Now a couple of things to keep in mind. First off, there is the very real aspect of interest that throws this simple version of the equation off. Secondly, in the case of a mortgage, make sure that your extra payment is going towards the principle of the loan, not the interest.
Well, we hope that you’ve enjoyed this little trip down debt-free lane. We’ll be posting a tool that will automate this a bit for you in the not to distant future, so come check back often. While you’re here, you might as well sign-up as a registered user. Registration is free and you will receive access to additional content.