If you’re not up to your eyeballs in debt, consider yourself lucky. Millions of people each year find themselves in tough financial situations. In some cases, they’ve done something irresponsible but in others, they’ve just been hit with some bad luck. Whatever the case, the best way to deal with debt is to avoid it all costs. Here are a few habits to help you stay in the black.
1. Spend less than you make.
This is common sense yet so many people make this mistake. In some cases, the necessities (home, transportation, food, etc…) really do exceed income – especially if someone has recently lost a job, incurred an unexpected major expense or is otherwise affected by a poor economy. A lot of times, there’s some fat that you can trim. Some examples of expenses that should be minimal (or even eliminated) during lean times:
- Dining out.
- Entertainment (movies, sporting events, night clubs).
- Cable TV.
- Wireless phones (especially costly calling & data plans).
- Books, DVDs, CDs, other media (instead, borrow for free from your local library).
- Convenience foods.
- Designer shoes & clothing (only buy clothes if you absolutely need them).
- Sports & activities.
- Health club membership (sometimes this cost is offset by insurance, so it’s essentially no cost).
- Home décor.
- Gifts (try to re-gift unopened & unused items, or give something homemade).
With a little creativity and scrutiny of your spending, you’d be surprised what you can cut back on and what you really need.
2. Stop using credit cards if you can’t pay it off each month.
Credit cards are the easiest way to spend money and drown yourself with debt. Once you start carrying a balance on one or more cards, you get dangerously close to the death spiral. What typically happens is that if you overspend one month, you’ll probably overspend the next. So now in the second month, you not only owe the excess from that month, but also the excess from the month before plus interest. Before you know it, a couple hundred dollars of debt is now a couple thousand.
So once you can’t pay a balance off in full, stop using any and all credit cards until it’s paid off. If you have to, go lean and cut some expenses as outlined in Habit 1. Otherwise, you’ll be digging yourself into a hole that will become increasingly difficult to escape.
3. Don’t be tempted by special credit card offers.
Let’s say you owe $5000 on a credit card and then, as if sent from Heaven, you get an offer in the mail from another card for 0% interest for 12 months on balance transfers. You probably think that you can transfer the balance and pay it down over the year and you’ll be saving yourself the interest. Not quite.
First, there’s usually a fee for making the transfer (typically 3%) so as soon as you transfer the balance, you now owe $5150. That’s not so bad considering that you’d probably accumulate that in interest in two months. But you’re not solving the initial problem of spending too much each month. So you might be tempted to make the minimum payment on the new card each month (perhaps $50) to keep up with your other card(s). So then at the end of the year, you have two cards that you now need to pay off.
4. Be careful with credit consolidation services.
There are dozens of companies on TV that promise to help you get out of debt. What many of them do is take all your debt and consolidate it into one loan so all your payments go through them. Of course, there are hidden fees, interest rates, etc…. Some offer to negotiate away some of your debt, but this could mess up your credit rating. So just be sure you know what you’re getting into.
5. Use loans carefully.
I get disgusted when I see ads on TV recommending you take a home equity loan for foolish purchases such as a vacation, boat or other luxury item. That’s one sure fire way to get yourself into financial ruin. There are plenty of reasons to get a home equity loan, but frivolous spending isn’t one of them.
Home equity loans are sometimes used to get out of other debt. It’s tempting because you can roll your debt into a low interest loan that you can pay over five to ten years. It’s sometimes a good option for people that accumulated a significant amount of debt due to a temporary setback such as a layoff or emergency expense. Again, as long as your monthly spending is under control and you’re not adding additional debt, this could be a viable option. Just keep in mind that if you can’t pay back the loan, you could potentially lose your home.
A safer bet is to take a loan against a 401K plan. This assumes that you have double the amount you need to cover the debt in your 401k – you can only borrow up to 50% of what’s in there. With these loans, you do pay interest but that interest goes back to you. The drawback is that money is no longer growing in your investment account, so if the stock market skyrockets, you lose some potential income. Of course, if the market drops, you’re getting a fixed rate of return back. In the event you can’t repay the loan, whatever balance is left on it is treated as income so you’ll need to pay taxes on it.
If you are considering either of these options, be sure to talk to your financial advisor, accountant or bank for guidance on your particular situation.
The bottom line is to control spending to avoid debt in the first place. If you’re already in over your head, find someone you can trust to help you. A good financial adviser is a great start. If you don’t have one, talk to an accountant or banker. They can often advise you on strategies to help you get out of debt. Another option is to pick up a part time job, even if it’s for only $10 per hour, and use that income to pay down your debt. If you have something of value to sell such as a collection, that could be another way to raise the money you need. So think creatively and ask people you trust for ideas.