The 3 Step Strategy for Paying off Debt and Saving Money at the Same Time
Paying down debt can be a daunting task. There is no denying that. Somedays it might even seem like an impossible task, but it doesn’t need to.
By following a basic three-step plan -- tracking your monthly income and expenses, establishing good saving habits, and then using what you have learned from the first two steps to begin reducing what you owe -- you can rid yourself of the debt trap over time. With a little self-discipline and some faith in yourself, your financial picture can change for the better in about six months.
1. Track Your Income and Expenses
The first step is to start tracking your typical income and expenses for one month.
Also figure out your expected and unexpected expenses for a year's time -- auto and home repairs, gifts, vacations, etc. -- and divide that number by 12. Once you have a record of your spending, compare your monthly outlay with your monthly income.
If you have a surplus of cash after all of your expenses are accounted for, then congratulations! This isn’t going to be too challenging. Use the extra cash that you might previously have been spending on going out or on superfluous purchases and use this to start paying down your debt and building your savings. Yes, you may have to cut back on some things while working on reducing your debt, but in the long run, avoiding high-interest charges should be your priority.
What if your monthly cash flow is in the red?
Things get a little more challenging if after reviewing your monthly expenses you find that you have NO excess cash leftover. Now would be the time to start cutting expenses. Do you really need cable and a streaming service? Are you paying for a gym membership that is never being used? Or could you switch to shopping at a less expensive grocery store? This is all part of establishing good personal finance and budgeting practices so you can reduce debt and build savings.
2. Start Building Your Savings
Once you feel like you have a better handle on your monthly cash flow and budget, you’ll need to establish good saving habits. This is step number 2. As we already discussed, each month, use your income to first pay expenses, then dedicate whatever is left to savings or reducing your debt.
Here is one way you can structure your saving:
1. Whenever you're paid, put only what you need to live on into your checking account. Like we discussed earlier, the money from your paycheck that is left over is what’s used to pay down debt and build savings. We’ll talk more about reducing debt in a minute.
2. In terms of saving, start with building your emergency fund by designating a portion of each paycheck to save for emergencies. This is the money that you don’t touch unless it really is an emergency. And no, a cruise to the Bahamas does not count as an “emergency,” even if it is 15 degrees in New Hampshire.
If your goal is to have three months' living expenses saved, you could reach your goal in 30 months by saving 10% of each month's pay -- or in 15 months by saving 20% per paycheck.
3. Put whatever is left into what we’ll call your "investments" account. This can also include “found money” such as birthday and holiday checks, annual raises, bonuses, money that is beyond your regular paycheck. Your “investments” account can be the same savings account where you keep your emergency fund or a separate account altogether. These savings represent more of your “put and take” account – money that could potentially be used for that cruise to the Bahamas.
Pay Yourself First.
I also recommend asking your employer about direct deposit. You can have money taken from your paycheck and placed in a savings account automatically. Because sometimes it’s easier to pay yourself first when someone else is handling the transaction.
If you are constantly having a hard time controlling your spending when it's easy to access your savings, consider putting additional stopgaps in place for yourself. Things like keeping your savings and checking accounts at different banks or restricting online access to your checking account– if you don’t see that money regularly, you will be less likely to spend it.
3. Paying Down Your Debt
Okay, step number 3, and this is the big one; actually paying down your debt. This is the one people typically find most challenging, but now that you are starting to get more control over your finances with steps one and two, it will be easier. Once you have a better grasp on where your money is going and how much money is available each month, you will be able to more effectively allocate it to paying down your debt. We take a deep breath, roll up our sleeves, and get down to business.
Here’s how we get started.
1. Make a list of all of your debts in order of interest rate, from highest to lowest.
2. Add up your liquid assets, including savings and investment accounts, if any.
3. List any major purchases needed in the next year.
4. Subtract your anticipated expenses from your liquid assets. What remains is the amount you may have to pay your debts.
Paying Off Credit Card Debt
Be smart and systematic about paying off your credit cards. Consolidate debt. Competition between credit card issuers is so intense that you can often negotiate your interest rate. Just be aware that some of the low rates quoted are "teaser rates," which only apply during the first 6 to 12 months you have the card.
Cancel your old cards. The most you need is two. And leave them at home unless you really need them.
Pay off your highest interest card debt first, making sure you avoid the "minimum balance trap." You can eliminate debt and save money by paying more than the minimum monthly amount on your credit cards.
For example, say you have $1,000 in credit card debt you need to pay off and the interest rate on the card is 18%. If you pay only the $20 minimum monthly payment you will end up paying a total of $1,784 and it will take you roughly 7 ½ years. If you were to pay $40 a month, you would be able to pay that off in a little less than 2 ½ years and it would only cost you $1,199 – that’s a $585 difference in the long run.
When it comes to eliminating debt, set up a realistic payment timetable and stick with it. If you need to readjust your timetable, do so. Don’t beat yourself up over it. If you have trouble, talk to a professional. Find someone who will hold you accountable and more importantly, someone who wants you to succeed in reducing your debt and building your savings.
Have questions? Let's Talk.
This material was created for educational and informational purposes only and is not intended as ERISA, tax, legal or investment advice. If you are seeking investment advice specific to your needs, such advice services must be obtained on your own separate from this educational material.
Securities offered through LPL Financial, member FINRA/SIPC.
This material was prepared for Anne Murray by DST Systems, Inc.