31 Days to Financial Independence (Day 7): Cutting and Minimizing Debt

“31 Days to Financial Independence” is an ongoing series that appears every Thursday on The Simple Dollar. You might want to start this series from the beginning!

Last time, we talked about something that I referred to as the “big boost“: going through your rarely-used and unused possessions in order to sell them off and use the proceeds to get your bills up to date, build a small emergency fund, and get a head start on your debt repayment plan.

Today, we’re going to talk in detail about that debt repayment plan.

The reality is that 80% of Americans are carrying some form of debt, with the median amount of debt measuring $67,900 spread across mortgages, student loans, car loans, credit cards, and other consumer debts. That’s a lot of debt, no matter how you slice it. It equates to hundreds of dollars a month spent on debt repayment and interest.

Here’s the problem with that picture: when you have hundreds a month vanishing out of your wallet to cover debt repayment and interest, that’s hundreds a month that’s not being spent on building the future that you want. If you recall, most people spend the vast majority of their working hours just earning enough to keep the wheels spinning, and debt repayment is a part of that. If your “true hourly wage” is, say, $10 an hour and you’re spending $800 a month on debt repayments, that means you’re spending literally 20 hours of each workweek doing nothing more than working to pay off debt. Every dime from twenty hours of your workweek is vanishing into the debt repayment black hole. There are 168 hours in a week, which means that you’re literally spending 1/8th of your life working to repay debt.

To me, that’s not living. That’s not freedom.

Instead, it’s far better to be spending those hours working toward establishing financial independence and achieving the big life goals you have for yourself. Clearing out your debt and eliminating those monthly debt payments is a huge step in that direction.

But how do you get from here – a median debt level of $67,900 – to there – a debt level of $0?

The way to do that is by first implementing a debt repayment plan in which you have an organized and sensible plan for eliminating all of your debts, and then walking through each area of your spending to compress and eliminate wasteful expenses, which is the “fuel” you need to make that debt repayment plan run.

Today, we’re going to focus on that first part: the debt repayment plan.

A debt repayment plan is really simple. It’s nothing more than a list of all of your debts, organized by simple criteria (usually interest rate). Each month, you make minimum payments to all of the debts on the list along with the largest possible extra payment on the debt at the top of the list. When that top debt is paid off, you remove it from the list, so now you have a little more to contribute to large extra payments on the new top debt on your list. You just keep repeating this until the list is done, at which point you’re free from debt.

It’s a simple framework, of course, but there are quite a few little things you can do to really make this thing hum. Let’s get started.

Exercise #7: Building a Debt Repayment Plan

By the end of this exercise, you’re going to have a debt repayment plan in place. You will have optimized it so that you’re going to be spending as little money as possible to make debt payments, meaning you have the maximum amount of money available each month to really hammer that top debt. You will have used the money from your “big boost” to get it started, as well.

Let’s roll.

The first step is to simply collect together all of your debts into one place. Go through the last month or two of your mail and get out the most recent statements for all of your debts – your credit cards, your mortgage, your student loans, your car loans, and anything else. Collect all of these items together into one place before you get started.

Next, make sure that you have something with which you’re comfortable making a simple table. A couple pieces of paper and a pen would work really well. A spreadsheet program, if you’re comfortable with one, works like a champ.

What you’re going to do first is to create a simple table with six columns. The first column is the name of the debt. The second column is the current balance of the debt. The third column is the current interest rate of the debt. The fourth column is your current monthly debt payment. The fifth column is the account number for the debt. The final column is the customer service number for the debt. Leave some space next to the interest rate and the monthly payment on this table because ideally that number is going to change.

The next step? You’re going to contact each of these debt holders and look for a way to lower that interest rate. For each and every debt you have listed, call the customer service number and use your account information to talk to a customer service representative. Your goal at the end of the call is to achieve a lower interest rate on that debt.

Here are some tips for making this process really work well.

First, be polite, no matter what. Never, ever, ever get angry with a customer service representative. The truth is that the vast majority of them want to help you but are unable to do so, not because of their choice, but because of the company’s policies and tools. It’s very rarely the fault of a customer service rep if your situation can’t get resolved. However, if you get angry, all you’re doing is ensuring that the customer service rep that you’re talking to will never go the extra mile to try to find a resolution for you. If you’re polite and kind, you’re going to find that sometimes they will go above and beyond to help you, a result that anger will never achieve. If you get angry, get off the phone and channel that anger elsewhere.

Second, ask the customer service representative whether they have the capacity to change your interest rate or other aspects of your debt. If they do not, ask to speak to their supervisor or to someone who can. Don’t exhaust your breath talking to someone who can’t actually change anything about your situation.

Third, when you are able to talk to someone who can actually change aspects of your debt, emphasize that the reason you are calling is that your current financial situation makes continued steady payment of the debt under current terms difficult. Your financial situation is changing. You’re looking at the future now instead of the present, and you’re also recognizing how perilous your current financial state is. Emphasize the fact that you’re walking a financial tightrope right now and even the tiniest slip is going to cause some problems.

Fourth, be aware that they may reduce the credit limit on one of your credit cards or cancel it entirely. This is how some credit card companies respond to customers that they consider marginal. If you consistently keep a card fully paid off, this may be their response. Similarly, if you consistently stay at your credit limit and sometimes miss payments, they may respond by cutting your credit limit or closing the card. You should never be in a situation where a card closing causes you to be in financial distress, but if you are in such a situation, be aware that it can happen when you’re discussing a rate change with a credit card company.

Finally, focus more on a reduced interest rate, not reduced monthly payments. You might think that such things go hand in hand, but they sometimes do not. A reduced monthly payment will happen if there’s no change in the length of a loan, but if they’re also altering the length of your loan repayment, monthly payments can stay the same or even go up a little. That’s fine. Your goal is to minimize the amount of interest you pay over the long run.

What about refinancing? If you have a mortgage, one option you can consider to reduce your interest rate is mortgage refinancing. In fact, that’s the option that your mortgage holder will likely discuss with you if you call them. Refinancing essentially means that you’re starting over with a new mortgage, one with a new interest rate that reflects current interest rates and your own current financial state (if you have good credit, that means a pretty good rate).

You may want to shop around for refinancing options by talking to several banks that are in the business of refinancing. You should be seeking the lowest interest rate possible, even if that means some fees up front in the process.

Again, this doesn’t necessarily mean that your payments will go down. If you refinance a 30 year mortgage into a 15 year mortgage, you may actually see a small rise in your monthly payments, especially if you’re just a year or two into the mortgage. Don’t worry – it’s fine. It means that even if you make minimum payments, you’ll have the debt paid off much faster than before.

What about student loan consolidation? Again, student loan consolidation is an effective way to reduce the interest rates on your loans. You’ll similarly want to shop around for student loan consolidation options, and, again, you may end up in a situation where your overall payment goes up slightly if you agree to a shorter term with a lower interest rate. Over the long term, that’s a good thing.

As you go through the process of talking to each lender, you may find yourself reducing the interest rate and changing the monthly payment on your various debts. Mark those changes on your sheet by simply crossing out the original numbers and writing in the replacements. We’ll worry about organizing them later – for now, just replace the old data with the new data in the most convenient way possible.

Once you’ve talked to each and every lender and figured out your plans for student loan consolidation and/or home refinancing, you’re ready for the next step, which is converting all of this information into a debt repayment plan.

There are really two main options for doing this.

The first option is what I call the “least payment” model. If you use this route, you are going to be paying the least possible amount in interest payments to your lenders. Over the long term, your total bill is going to be lower than any other plan you might come up with.

So what’s the drawback? The drawback is that you may find yourself hammering away at a single debt for years without ever actually paying any debts off. If the first debt on your list has a big balance, it’s going to take quite a long time to get rid of it, especially if you’re making minimum payments on other debts. This can sometimes cause less persistent people to get frustrated and give up on their debt repayment plan.

The other option is the Dave Ramsey “debt snowball” model. With this model, you’re going to space out the payoffs of your loans so that you get to enjoy the victory of paying off a loan as regularly as possible. Ideally, you’ll experience that success over and over again frequently at first and then the celebrations spread out a little as you start facing your biggest debts.

The drawback here is that you might end up paying off debts in such a way that your total overall payments are a bit higher than they would be with the other plan. In other words, you might spend a little more with this plan over the long haul, but it’s better designed for the psychological benefits of success in paying off individual debts.

Both plans are perfectly fine. Both will get you to your destination and, honestly, unless your situation is extreme, the plans will likely end up being fairly similar in execution anyway.

So, pick one strategy and go with it.

Once you’ve decided on your strategy, you’re actually going to make your debt repayment plan.

Take that second sheet of paper (or a new spreadsheet document) and make the same columns – debt name, interest rate, current balance, monthly payment, account number, and customer service number. Except now you’re going to copy over data from the first table, but in a new order.

If you decided to use the “least payment” model, copy the debts over by interest rate, with the highest interest rate first. Write down the info for whatever debt has the highest interest rate in the first row, then cross it off the other page. Then, write down the info for the debt that now has the highest interest rate in the second row, and then cross it off the other page. Keep doing this until you’ve listed all your debts ordered by interest rate with the highest interest rate on top.

If you decided to use the Dave Ramsey “debt snowball” model, copy the debts over by remaining balance, with the lowest remaining balance first. Write down the info for whatever debt has the lowest remaining balance in the first row, then cross it off the other page. Then, write down the info for the debt that now has the lowest remaining balance in the second row, and then cross it off the other page. Keep doing this until you’ve listed all your debts ordered by remaining balance with the lowest remaining balance on top.

Regardless of the model you chose, this is now your debt repayment plan. Here’s how you use it.

Each month, you’re going to make a minimum monthly payment on every debt except for the one in the very first row. You need to do this to keep from accruing late fees and damaging your credit.

What about that debt in the very first row? Each month, you’re going to make the biggest possible payment you can on that debt. Throw every spare dime you can at it. Ideally, you can sometimes pay off the full debt with one payment, but many months that won’t quite work, so just make the biggest payment you can.

Whenever new bills come in, update the remaining balance and the monthly payment for each of your debts, then repeat this entire practice. Make minimum payments on each debt, then make a giant payment on the first debt on the list.

When the top debt is paid off, feel free to celebrate in some non-financial way! It’s a great step on your road to financial independence! The next step, then, is to move on to the next debt on the list. It now becomes the “first debt” in your plan, so you’ll make minimum payments on the rest of the debts and you’ll make a giant payment on that new “first debt.”

What you’ll find is that when you start paying off debts, it becomes easier and easier to make really big debt payments each month because you have one less minimum monthly payment to worry about. Instead, you can channel the money that used to go to that minimum monthly payment into a giant overpayment on the current top debt. You’ll find that the whole thing accelerates over time!

There are a few little caveats worth thinking about, though.

First of all, if you have any remaining money from your “big boost“, use it to make a giant initial payment on the first debt on your list. Perhaps you can pay the whole thing off… or even pay off the first couple debts. That’s a great way to get started on this whole plan.

Second, avoid adding any new debt unless you absolutely have to. If you find that you’re on the verge of putting things on the credit card because there’s no money left after your giant extra payment, don’t do it. Instead, next month, make your giant extra payment a little bit smaller and keep giving yourself breathing room in your day-to-day life.

Third, if an emergency causes you to pull money out of your emergency fund, slow down with your extra payments and refill the fund. Yes, sometimes things are going to happen that cause you to tap that emergency fund that we created last time. That’s okay. Just make sure that you refill the emergency fund. While you’re refilling, just make minimum payments on all of your debts and put a big lump of money into your emergency fund.

Finally, you’ll find that frugality amplifies this whole thing. Finding smart ways to cut your spending, even if it’s in a subtle way like reducing your electricity bill by $5 a month, ends up having an impact on this debt repayment plan. A $5 cut on your electricity bill means $5 more toward your debt repayment plan each month without any change in your lifestyle, which is an amazing thing!

That’s why, over the next several stops on this road to financial independence, we’re going to look at the pieces of the typical American budget, one by one, and look for ways to reduce those costs. The purpose isn’t to cause you to live a miserable life of austerity, but instead to “empty out the shallows,” a concept we talked about earlier in this series. You’re shooting to minimize the spending in the areas of your life that you care less about so that you can live the life you want to live in the handful of areas that you do really care about.

That means that throughout those entries, you should focus on cutting back mostly on the areas that don’t seem overly painful. Don’t get focused on the ideas that seem like they would really detract from your life – cutting there isn’t worth your time. Instead, focus on the other tactics, the ones that don’t interfere at all with the parts of your life that you want to go “deep” on.

See you next time!

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