Guide to becoming Debt Free

Overview

To pay off your debts more quickly, there are a several things you can do:

• Make sure that you pay off your debts in the correct order ('snowballing')
• Use spare cash to pay off your debts rather than save!
• Reduce the rate of interest you are paying, so that more of your monthly payment goes to reducing the debt
• Decrease your monthly expenditure
• Increase your income

That doesn't sound too complicated does it. Let's take a closer look at each of them.

Pay off debts in the correct order (snowballing)

Snowballing is appropriate if you can pay all of your minimum monthly payments and have some cash left over. It is a great way to pay off your debts more quickly and will save you a lot in interest payments. The idea of snowballing is to pay the minimum amounts on all your debts, whilst throwing the maximum amount you can at the debt with the highest APR. Once you have paid off that debt, then you throw everything that you can at the debt with the next highest APR; and so on. Here's an example of how it works. Let's say you have 3 credit cards:

That's a total credit card debt of £16,000 and minimum payments of £500 per month. If you keep to your minimum payments, it is going to take 37 months to pay this off.

Now, let's say you have an extra £200 per month spare. What you do, is you pay this off the most expensive debt: the £1,000 debt at 22% APR, whilst continuing to pay the minimum amounts on the other 2 cards. So instead of paying off £50 per month on Card 1, you will now be paying off £250 per month. As you gradually pay off this debt, the minimum amount on your statement will reduce. Don't reduce your payment - keep this at £250 per month. After 5 months you will have cleared your first card - a significant milestone!

You now have an extra £250 per month to pay off the next card with the highest APR: Card 2 at 12%. So, you will now add this £250 to the minimum £150 which means you will be paying £400 per month off Card 2. As you have been paying the minimum payments on Card 2 the increased payment on this card means that you will pay this off within 17 months. Your snowball is rolling!

Once you have paid off Card 2, you will then have an extra £400 per month to add to the £300 you are paying - a total of £700 per month! This means that you will have paid off the whole debt within 25 months, a whole year less than you would have by just paying the minimum payments and you will have saved a bundle in interest charges.

There is a great snowball calculator at the whatsthecost website for working out the best order to pay off your cards and how long it will take you to become debt free.

Use spare cash to pay off debts

For the most part, saving is a great thing to do. However, if you are in debt, it really doesn't make financial sense at all. Why is this? For a start, the interest rates on your debts will be anywhere between 6.9% and 30%, but the interest rates on your savings will probably be under 6% (at the time of writing in April 2008). But it is even worse than that if you are a tax payer. A standard rate tax payer will be paying 20% tax on the savings account interest and a higher rate tax payer will be paying an enormous 40% tax on the savings interest. Even if you have a good savings account paying 6% AER, the effective interest rate after tax is 4.8% for a standard rate tax payer and 3.6% for a higher rate tax payer. Now compare those rates to your credit card rates! So, if you have debts and savings at the same time, then you are really not making your money work for you in the way it could. You should seriously consider using your savings to reduce your debts. You will be better off.

Before we leave this topic, we should point out that it does make sense to have a small "Emergency Fund" if you are in debt. This can be used to pay for repairs to essential items such as your car or your washing machine, without having to borrow more to do so.

Reduce the Amount of interest you are paying

Credit cards offer flexibility and, when used sensibly, can offer some significant benefits to the consumer. However, they can be a very expensive way to borrow money: sometimes at rates well in excess of 20% APR. These high interest rates mean that a significant part of your monthly payment goes to paying off the interest, rather that the original amount borrowed. If you can reduce the amount of interest you are paying, then more of your payment goes towards reducing the debt. Many credit cards offer low rates if you transfer a balance from another card. This give you the opportunity to reduce the cost of your debt and to repay the debt more quickly. For a more detailed description of how you can do this, read our Guide to Balance Transfer Cards.

Decrease your monthly expenditure

For many people, reducing their expenditure really is key when trying to pay off their debts. Often, major debts are built up over a period of years as a result of month by month over-spending. For example, if someone spends £200 per month more than they earn, every month for 5 years, then they will have borrowed £12,000. If you include typical credit card interest rates over that period, then the total debt would be in the region of £20,000! If you add in a new kitchen to that and a couple of family holidays, it is easy to see how a debt of £30,000 could be built up in just a few years.

So getting a good grip on your expenditure is critical. If you are spending more than you earn, then your debts are going to increase until they become a serious problem. Use our SOA Calculator to document your income, expenditure and debts. When you have completed it, you can post it on our discussion forum using the calculator's "Format for Make Sense" button. You will get useful feedback from others to say how you can cut back your expenses.

Increase your income

Increasing one's income is an area often ignored when coming to pay off debts, because we tend to think of our current income and employment as being something fixed. It doesn't have to be. Could you take a part-time job to help bring in some extra money? If you do some bar work then you will be earning money and may also enjoy it as a night out, thus increasing your income and reducing your entertainment budget at the same time! If you feel that you are making a great contribution at work, you might consider asking your boss for a pay rise. It is often said that, "if you don't ask, you don't get". Could you move to a better paid job? Do you have a hobby that you could earn some money from? Think creatively about what options are available to you.

If you have a spare room, you could take in a lodger and take advantage of the Government's Rent a Room Scheme which allows your rental income to be tax free.

One very important thing that you should not overlook is to see if you are entitled to any state benefits that you may not be claiming. You can find out more about benefits from this Government website. Another useful website for working out what benefits you are entitled to is www.entitledto.com .

Conclusion

Having had your lightbulb moment, you have taken the first step to paying off your debts. We hope that this short guide to becoming debt-free has inspired you to make it happen.