HOWTO: Get Out of Debt

Posted on July 3, 2007

Yesterday I made the final payment on the last bit of debt I was carrying — my student loan.

This was the last step in a project I set for myself three years ago. Back then, I was in the same position as most Americans: I was making payments on a car, on student loans, and on multiple credit cards.

I wasn't alone. The average American carries $8,652 in credit card debt; a middle-class family these days spends more than a third of their income making payments on personal debt. In 2006, average household debt reached a stunning 134% of average household income — the highest level ever. When you're over-leveraged like this, all it takes is one crisis — a lost job, say, or a health emergency — to send you over the edge into bankruptcy.

I didn't want that to be my story, so I decided to attack the problem systematically. It took a little while, but now the project is complete; and I thought I'd share with you the strategy I came up with, in case you've got some debt of your own you'd like to retire.

The key thing to understand about consumer debt is that it isn't the debt that keeps you in debt; it's the interest.

It's absolutely shocking, when you think about it, how much interest people are paying on their debts. While interest rates on bank loans have been low over the last few years, consumer debt interest rates have exploded. Credit cards have interest rates as high as 30%; even the good ones are typically in the 15-20% range. Other personal debt vehicles are even worse: payday loans, for instance, can carry interest rates as high as 99%. At these rates, the original amount of the loan quickly turns into something much larger. 

The good news, though, is that we can use this fact to build a strategy for getting out of debt.

What you want to do is prioritize your payments so that you're paying off the highest-interest debt first. Make a list of all the things you're making payments on, and sort that list by interest rate, with the highest one first. That list will tell you which loan should be your first priority.

The first way to cut down that highest-interest loan is to transfer debt to lower-interest vehicles. If you have more than one credit card, compare their rates and transfer as much of your balances as possible from the higher-interest cards to the lowest-interest one. Credit card companies usually make it easy for you to do this (they're probably spamming you with "balance transfer checks" in the mail).

Once you've done this, concentrate your payments on the remaining highest-interest balance. Make the minimum payments on the others, and send everything you can spare to pay off the high-interest card. Once it's paid off, move on to the next one on the list, and pay it off, working your way down the list. (What about the other debts? That's why we moved them to lower-interest vehicles, to minimize the amount of interest they build up while we're focusing on the most expensive loan.)

Progress will seem slow at first when you use this approach; but it will get faster and faster with time. As your principal on the first card gets paid down, the interest payments you owe will go down with it, freeing up money to pay down more principal. Once you've got that first card paid off, you can take the whole amount you used to pay on it and apply it to the second card. And so on.

Once you've got your credit cards paid off, you can turn your attention to things like car loans, mortgages and student loans; these typically have quite low interest rates, so they're a lower priority. Figure out the absolute minimum you can pay on these, and apply the cash to your higher-interest debts.

That's how I got out of debt. And if you've been wanting to do the same, that's how you can do it too!