Do’s and Don’ts When Getting Out of Debt

A significant part of my practice at the Baron Group is helping families get out of debt. Without a doubt, being debt-free is not only a requirement for financial freedom but also in most cases what is needed to be able to achieve financial goals and be able to retire.

The unfortunate reality is that so many of us, even the most financially disciplined ones are forced at one time of our life or another to take on debt due to unforeseen circumstances, very often urgent, such as job loss, medical emergencies, funeral expenses etc. And once there is too much debt we all know what happens – higher interest rates which then make it difficult to repay, inability to take advantage of the current lower interest rates environment in order to refinance a home mortgage for example… and it really becomes a vicious circle that it is difficult to get out of.

However, if getting out of debt is approached with a methodical plan which is followed diligently, then being debt-free could become a reality sooner than you had hoped for.

Below I have listed the 5 most important Do’s and the 5 most important Dont’s when it comes to getting out of debt.

DOs:

1. DO Check your credit report

Begin by obtaining a consumer credit report. First, make certain the information reported is accurate and also use it as a guideline to accomplish the second very important step – set a budget.

2. DO Make a budget

Once you have identified all debts from the step above, then compare those against all sources of monthly income and set a budget. It really helps to list all income and expenses and figure out what the difference is. Then identify the debt with highest interest rate and create a plan to repay that debt first, then the one with the second highest interest rate etc. Be systematic and precise in your approach! Also, be realistic! This will make the difference between succeeding and failing to follow your budget.

3. DO Stick to your budget

Even if you create the most efficient budget, it would not mean much if you do not stick to it and are unable to follow. Your budget will probably mean a more frugal lifestyle than what you are used to but keep reminding yourself that it is a temporary solution so you can accomplish your long term financial goals. Think of the day when you will be debt-free and focus on that. Because sticking to your budget is really what will put your on the road to financial freedom.

4. DO Use tools to find savings

The good news is that sticking to your budget may not be so difficult because there is a strong chance that there currently are ways within your own accounts. There is variety of tools to help you accomplish that. From Personal Finance software like Quicken thru completely free online resources like Mint.com to more robust and comprehensive tools like Your Family Bank®, the help is there, so take advantage of it.

5. DO Beware of “Get Out of Debt” Companies

While sometimes it is indeed possible to renegotiate credit terms beware of companies that promise you miracles. In my over 20 years of experience, I have not seen credit card companies lower interest rates drastically just because you asked them to do so. If the promises those “Get out of Debt Fast” companies make seem too good to be true, they probably are.

DON’Ts

1. DON’T Incur more debt to get out of debt

In some cases it makes sense to transfer balances from high interest rates accounts in order to take advantage of zero interest balance transfer option but beware of the zero interest expiration date and include that in your long term budget. But it is important to note that this makes sense to do between already existing accounts. It is rarely prudent to open new credit card accounts in order to repay existing ones. Remember, you goal is to break the vicious cycle, not to keep turning within it!

2. Cash out a 401(k) to get out of debt

Liquidating a 401(k) account is an option when separating from an employer but it is rarely a smart choice to make considering the early withdrawal penalty incurred by anyone who is younger than 59 ½(usually 10% of the balance) and the income taxes that will need to be paid on that transaction (depending on your tax bracket it could be anywhere up to 35%). Not to mention the interest lost over time if the account is rolled over to another 401(k) or an IRA. As a rule of thumb, think of cashing out a 401(k) as a very last resort when all other options have been exhausted. A plan to get out of debt usually doest not qualify for a life and each situation when you should resort to such drastic measures. 

3. Don’t live in denial

Ignoring the reality is never the answer regardless of how unsettling the truth can be. Just being satisfied with the status quo will not help you achieve your financial goals. Creating a financial plan and following it, even if it means some sacrifices along the way is what is going to help you get debt free. Doing nothing will only make your debtors richer.

4. Do not be late

Sometimes even small mistakes can cost a lot. These days credit cards companies are quite unforgiving when it comes to late payments. Paying a bill late will, in most cases, automatically trigger an interest rate increase which will then set back your efforts and keep you further away from accomplishing your goals. Keep meticulous track of payment due dates, setup for automatic payments, do make all efforts not to be late on payments.

5. Do not forget your Emergency Savings Fund

Following your financial plan to get out of debt should not come at the expense of your emergency savings fund. Do not liquidate your savings to repay debt and even when you are in the midst of aggressively repaying debt, continue saving. The monthly amount doesn’t have to be huge, as long as you keep adding to your piggy bank.

Getting out of debt takes a good plan, determination to follow it and it may mean sacrificing some “wants” and “nice to have”s… But it is all worth it!

Bets of luck!