Monday, September 17, 2007

How to Start a Debt Reduction Plan

Whether you simply want to pay off your mortgage or car loan sooner, or youve run up a huge pile of credit card debt, starting a debt reduction plan is always a good idea. Follow these five steps to setting up your own debt reduction plan:

1. Find out where your money is really going. You cant cut your expenses if you dont understand where youre spending your money in the first place. Pull out all of your receipts, credit card bills, and bank statements for the last 3 6 months. Make a list of everything you spend money on, by breaking things down into categories (food, entertainment, clothing, travel, bills, interest, taxes, etc.). Then figure out what percentage of your income is going towards each group of expenses. While you cant change certain expenses, you can change most of them. Decide what general areas you can cut expenses in, and which areas you should be spending more money on.

2. Trim unnecessary expenses. Now that youve decided what general areas you want to cut expenses in, start looking at specific bills and receipts. Some expenses will be justifiable, and others wont. Just because something was inexpensive, doesnt mean you can justify spending money on it rather than putting more towards reducing your debt. For example, perhaps you spent $80 on a pair of jeans, and $10 on a clearance top you found. At first glance, you might think the $80 expense could have been cut by finding a less expensive pair of jeans, while the $10 expense is easily justified, but thats not necessarily so. If you truly love that pair of jeans, theyre of high quality and will last a long time, and youll wear them regularly, then the $80 expense is justifiable. But if you purchased the clearance top simply because it was cheap, and youll likely wear it only on rare occasions, then that expense is the unjustified one that could have been cut. You need to evaluate the benefit of what you spent the money on versus the benefit you would have realized if you had spent that money paying down your debts.

3. Set a timeline and goals for yourself. Youve already decided where you can cut your expenses. So what should you do with that extra money in your pocket? Each debt reduction plan will revolve around different goals and timelines. Set your own now. For instance, if you have a 30 year mortgage, your goal might be to pay it off in 20 years instead, to save thousands of dollars in interest payments. If you want to pay off your credit card debt, your goal might be to pay off one card completely (and get rid of it) by the end of the current year. Your goals and timeline will be highly personal, so spend some time deciding whats most important to you.

4. Pay the small, high interest debts first. When youve decided on a timeline and general goals for yourself, its time to pick the specific debt to deal with first. The general rule is to start with the smallest debt with the highest interest rate. That usually means a credit card. By eliminating a small high-interest debt, youll cut down on the total interest youd pay over time, and by choosing a small debt first to eliminate completely, youll free up those regular payments to go towards a larger debt later. Once that small debt is paid off completely, keep paying those monthly payments, but pay them towards your mortgage, car payments, or other large expenses.

5. Reward yourself with savings. As you reduce your debt, make sure theres something in it for you (although for some, the peace of mind may be enough). One of the best ways to reward yourself is to set up a savings account, money market account, or some other kind of interest-bearing account with the money you used to put towards your debts. For once, let interest rates work in your favor, and when a large expense comes up youll have funds to draw from (whether it be an emergency or a pleasant vacation). You wont need to rely on creditors when you can rely on your accumulated wealth.

Copyright 2006 Stephen Ashton

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