One really important piece of your Frugal Fresh Start is getting a handle on any debt that you have. Our own current financial goal is to pay off mortgage debt, so this is a topic that’s always at the top of our minds.
If you don’t have any debt at all, congratulations! You can skip this post and take a day off. For everyone else, it’s time to get all of your debt out in the open.
While you can’t expect to tackle your entire debt within this 28-day challenge, laying it all out and coming up with a rough long-term plan is the first step.
Maybe paying off some of your debt is part of the six-month goal that you set on Day 1. That’s great! Now, you want to get a true picture of where you stand regarding debt.
Find Out How Much You Actually Owe
If your debt is spread out across multiple creditors, get all the details in one place. Get out your workbook and turn to Day 11. Find the form called “Debt: The Big Picture.”
Record the following details about each of your debts:
- Name of the debt
- Total amount owed
- Interest rate
- Minimum monthly payment
- Monthly due date
Don’t let seeing all your debt laid out in black and white discourage you! Let the big picture motivate you to take this frugality business seriously so you can get yourself to a better place financially.
Realistic Sample Debt Payoff Case
Let’s say that you have five debts: a mortgage, two car loans, a credit card balance, and a medical debt. For this example I’ll use debt amounts that are close to the current national average for American households.
The mortgage is just over $200,000, with a monthly payment of $1029. One car loan has a balance of $11,498 and a monthly payment of just under $500. The second car loan is about $2000 with a monthly payment of $237. There’s also a single credit card with a balance of almost $11,000 and a medical debt of $13,500.
Make Sure You Can Cover Minimum Payments
Now that you have it all out in front of you, the first thing is to make sure that your budget is set to cover the minimum payments on every debt. In your workbook, total up the complete amount of debt owed and the sum of the monthly minimum payments. If it’s at all possible, it’s important to pay at least the monthly minimum on each of your debts. Otherwise, you end up with penalties and the debts get bigger and harder to pay off.
Your budget from Day 7 should include debt payments that at least equal your minimum payments. If you missed a debt when you were putting together your budget, now’s the time to go make some adjustments!
If you’re in a situation where there’s no way, no matter how much you cut from your budget, to make the minimum payments, I’m so sorry. That reality is hard, but it is real. You may need to choose which debts are most important to stay current on, focus on increasing your income in any way you can, and start thinking about seeking complete or partial debt forgiveness. It’s probably also a good idea for you to find some community debt counseling to help you put together an individualized debt reduction plan.
For the rest of us, we’ll follow the same general plan. Assuming you have more than one debt, you will make just the minimum payments on all of your debts, except one, and for that one, you’ll throw every dollar you can find at it until it’s completely eliminated.
Set Yourself Up For Debt Payoff Success
But wait! There’s one other thing to do before diving straight into a serious debt payoff plan. That is to get an emergency fund in place. An emergency fund is just some money set aside to handle financial emergencies without derailing your entire debt payoff plan. You never touch the money unless you have a real financial emergency, but having it there, just in case, gives you a sense of security, even amidst serious debt.
It also keeps you from getting derailed on your budget as you get started. In the first months with a new budget you’ll find expenses you hadn’t considered, and you’ll realize that your expected spending estimates for some budget categories were way off. This is normal. It’s actually great, because it means you’re learning more about your financial reality. But it does mean it’s easy to blow your budget early on.
You’ll adjust your budget each month and get better, but in the meantime, your emergency fund can temporarily double as your “I’m Getting Better, But I’m Not Quite A Budget Pro Safety Fund.” Having a little cash set aside helps when you might need to cover an expense you hadn’t planned for. Go ahead and use the emergency fund, and then fill it back up again as soon as you can.
But don’t make it a habit! An emergency fund is primarily meant for real, unforeseeable emergencies, not just to cover habitual lazy budgeting.
Within a few months of closely tracking your spending, you should have your emergency fund full and sitting there, untouched, except for completely unforeseeable, pants-on-fire type of emergencies. If you don’t already have an emergency fund, focus on building one up as the first step of your debt payoff plan.
A standard starting point for an emergency fund is $1,000, though for a lot of people that is on the low side. I can’t tell you what the right number is for you. You’ll want to consider factors like what your “emergencies” have looked like in the past and how much your normal expenses are for a month. The size of your emergency fund will also depend on how long you expect your debt payoff to take. If you anticipate a longer debt payoff time frame, you’ll want to have more saved.
When we were paying off Mike’s law school student loans, we first built an emergency fund of one month’s expenses, about $3,000 at the time. After finishing those loans, we built our emergency fund up to 6-months. Because our monthly expenses now also include a mortgage, that 6-month emergency fund is about $30,000.
Choose a number that you are comfortable with. Your number is probably different than the next person’s number. Write your emergency fund number in the Day 11 section of your workbook, and start saving!
Make Your Debt Attack Plan
So now we’re back to today’s main idea, getting rid of your debt! Your budget includes all your minimum debt payments, and you’ll soon have the safety of an emergency fund in place. It’s time to make your plan of attack! Whether it’s a six-month plan or a six-year plan, you need a plan to get rid of your debt. I promise–it won’t just pay itself off!
If you just have one debt, it’s easy to know where to start, but if you have multiple debts, you’ll have to decide where you want to focus first.
Debt Snowball Method
The best way to pay off multiple debts is to focus your attention on one of your debts at a time while still keeping up the minimum payments on all your other debts. All the extra money that you earn and every dollar you save from other categories in your budget goes toward the one debt that you are focusing on.
When you finish paying off the first debt, take the amount you were paying toward the first debt (the minimum payment, plus whatever extra you came up with) and put it toward the second debt. When the second debt is paid off, take the minimum payments from debt one and two, plus whatever extra you can get, and use all that money to pay off debt three.
Do you see how your payments get bigger and bigger as you go?
The idea of focusing on one debt at a time, and rolling the payments from the debts you already paid off into the payment for the next debt you’re focusing on, is called the debt snowball method.
The big question is the order that you will put your debts in–which one you start paying off first. There are two main ways to do this. You can either put them in order from the smallest to the largest debt balance, or in order from the lowest to the highest interest rate.
Balance (Smallest to Largest)
Often, when people talk about the “debt snowball” method, they are talking specifically about ordering their debts by the size of the balance. That’s probably because this is the way Dave Ramsey teaches it. If you have to choose just one way that works best for the greatest number of people, starting with the smallest debt first is that way.
This method has you focus on paying off the smallest debt first, no matter the interest rate. You make minimum payments on all debts, and any additional funds go toward the debt with the smallest outstanding balance. When that smallest debt is paid in full, you take the monthly payment that you were making toward that smallest debt and add it to the minimum payment you’re making on the next smallest debt.
There are good reasons for choosing your smallest debt first, but the most important reason is that you get a quick win! The feeling of success you get when you finish paying off your first debt is so motivating! It’s a euphoria that helps you keep up momentum to work on your larger debts.
Interest (Greatest to Least)
The other way to order your debts is to pay off the debt with the highest interest rate first, then the next highest rate second, and then on down the line.
For a lot of people, the debts with the highest interest rate are the smaller debts anyway, so the order could be the same either way, but if your smallest debt is not your highest interest debt, you’ll actually pay more in the long run by paying the smallest off first.
Ordering your debts by interest rate will save you more money in interest, especially if some of your loans have much higher interest rates than others.
Mathematically, the best order to pay off loans is the highest interest rate first, but it’s not always easy to tell whether the amount of interest you save is a big deal or nothing to get excited about.
Debt Snowball Calculator
We love the Debt Snowball Calculator that the folks at Easy Budget put together. It calculates the total interest and final payoff date for each debt when you change the order of the payoff. As a debt-tracking tool, it also easily lets you see how much you save on interest and how much faster you get to your debt-free date when you pay more than the minimum. It even adjusts your total interest and your payoff date when your extra payment is a different amount each month.
I’m pretty good with Excel, and I could probably put a similar calculator together myself in a day or so, but I could also purchase the calculator for $14 (with code SMASHDEBT), save an entire day of Excel, and use the pre-made calculator as both a decision-making tool to choose a debt payoff order and a motivational tool to track the effect of extra payments on my debt payoff dates.
There aren’t very many extra things we suggest that people buy while trying to pay off debt. After all, the idea is to NOT spend extra money. But this Debt Snowball Calculator is one thing that I believe can really help people with more than a couple of debts maximize their debt reduction.
Back to Our Sample Case
In our sample case, the calculator shows that paying off our five average debts starting with the highest interest rate saves one month and about a thousand dollars over starting with the lowest balance.
I was actually surprised it was only that much. The interest rate is much higher on the credit card, but with the snowball growing as you go, it knocks out the credit card pretty quickly.
With a debt payoff horizon of several years, the $1000 isn’t a huge difference, but it’s still a thousand dollars. If you’re the sort of person who is motivated by strict rationality, and that saved $1000 gets you all excited, choose the logical mathematical option and start paying off your highest interest debt first.
But don’t discount the power of feeling like you’re winning. Paying off debt can get old fast, so if you’re the sort of person who would really appreciate crossing one debt off your list quickly, go with the smallest debt first.
Either way, if you’re faithfully rolling over your payments from one debt to another in a debt snowball, it’s amazing how fast you can go once you get a little momentum.
Choose the order that works best for your personality and your unique situation. Maybe you’ll do a combination of the two. You might even have your own additional factors that would lead you to choose a different debt first.
Day 11 Challenge
First, get all your debt recorded in one place on the Day 11 workbook form.
Second, make sure all of your minimum payments are covered in the budget you made on Day 7, and adjust the budget if you need to.
Third, set the order–which debt will you pay off first? Which second, and so on.
Finally, whether your next step is to build up an emergency fund or to start paying off your first debt, get started on it.
And because you’re cutting out one expense altogether in the Day 2 challenge, and you’re tracking every expenditure every day in the Day 3 challenge, and you’re cooking at home more often with the Day 5 challenge, and you’re lowering your fixed expenses and utilities with Days 8 and 9, you should have a chunk of extra money this month to get you started with a bang.
You’re on your way to being debt-free!