Making a Debt Management Plan - part 2
Debt Management Plan: Step 4
Assuming your disposable income from Step 2 of the debt management plan exceeds your monthly debt payments, you must now create a strategy for paying your debts and saving money. There are many ways to do this, but I recommend that you prioritize your debts as follows:
- If you have an installment loan (like a car loan) that is close to being paid off, go ahead and pay this first. This is because when an installment loan is close to being paid off, the payments tend to be quite high as a percentage of the debt owed. For example, your car payment might be $350 per month. If you only owe $1200, your monthly payment is close to 30% of the debt amount. Paying off this debt will free up $350 per month in your budget.
- In the case of revolving debt, either pay off your lowest balance or your highest interest rate. Economically speaking, it always makes more sense to pay off your highest interest rate first, but psychologically speaking, the sense of victory you get from paying off a debt in its entirety can make it more likely you will stick to your debt management plan.
- When you pay off a debt, take the money you were devoting to that monthly payment, and begin applying it to the next debt on your priority list, except:
- If your savings are not sufficient to cover three months of your expenses, you need to start saving immediately. In this case, when you pay off a debt, you should take a part of that monthly payment and save it and use the remainder to increase your payments toward your debt.
- If you have real estate debt, this should generally be the last debt you pay off - - unless the tax code is amended to eliminate the mortgage interest deduction. Generally, real estate debt is at a lower interest rate than most revolving debt, and it entitles you to a more favorable tax treatment - - at least for now.
Debt Management Plan: Step 5
The money you have left in your budget when you subtract your monthly expenses and your monthly debt payments from your income is your actual disposable income. If you do not have any disposable income, you simply cannot spend any money on entertainment items. The only thing you accomplish when you spend money you do not have is to increase your debt.
Saving money is a key component of any debt management plan. If your air conditioner breaks, and you have to put the new one on a credit card, you are incurring debt. If you have the money saved, you can pay for the new air conditioner in cash. Therefore, until you have a three month savings cushion, a large portion of any disposable income you might have should go toward your savings.
Of course, putting together a debt management plan does not mean you have to cut out all of your fun. Just try to be a little bit more careful with your entertainment dollar until you reach your savings goal. You might sign up for Netflix instead of going to the movies every week. Consider a picnic in the park instead of lunch at a fancy restaurant. If you have children, you might invest in an annual zoo pass and use it instead of spending money on trips to pricey amusement parks. Every dollar you save gets you closer to financial independence.
