Some things in the financial world can be done passively but if you want to get beyond debt , you have to work it differently. You can earn income passively, such as with interest and dividend bearing investments or rental property. You can save money passively through payroll deductions, and you can even prepare for retirement passively through retirement contributions and predetermined investment allocations.
But as I said, one area of your finances that can’t be worked out passively is debt. Debt requires action, as in active participation. Sure, you can pay your debts with payroll deductions in the same way you fund a savings account or retirement plan, but debt has an entire dynamic that requires you to take action. And it’s seldom just about paying the debt alone.
Since debt comes about as a result of a combination of factors—too much spending, not enough income, insufficient savings, financial disasters and, often, lack of discipline—it has to be worked out on multiple fronts.
Set up a budget
Many people get into debt because they don’t have a handle on their income and expenses. Money comes in from paychecks and other sources, you buy what you need, and at the end of the month maybe there’s enough income and maybe there isn’t. If there isn’t, a credit line is tapped to cover the difference.
If you have a budget, you’ll not only know where and how you’re spending your money, but you’ll also have the ability to control it. A budget lets you see where the money is going and to identify points of excess that need to be cut. A budget gives you control over your money, and until you have that control you won’t be able to get out of debt.
You must spend less than you earn
This is the foundational concept of personal finance. You can never become financially independent unless you have extra income that you can allocate to savings and investment, and that extra comes mostly from the difference between what you earn and what you spend. No matter what your income level is, you must lower your expenses to a level that is beneath it so that you can save the difference.
Savings are a critical part of getting out—and staying out—of debt
Often people who are deep in debt got to that position not because of extravagant spending, but because they had no savings to tap when they needed extra money. Savings are the exact opposite of credit; they represent a stored capital reserve while debt seeks to raise cash by creating a liability. As those liabilities grow and stack one on top of the other, you reach a point of no return.
You must develop some amount of savings—an emergency fund at the very least—to give yourself some breathing room so you won’t be tempted to use credit when you’re in a pinch. Savings are that balance wheel that keep your finances on a steady path.
You have to stop using credit
Debt is a big enough problem in itself, but an increasing amount of debt is an even bigger one. It’s not at all impossible to go so deep into debt that you’re forced into bankruptcy. That’s a place where you have no control over your financial destiny—you will have effectively transferred that control over to the court and your creditors.
The best way to put an end to that cycle is to stop using debt as a financial tool immediately. No effort to pay off debt will work until you reach a point where you no longer need it to function. Once you do, you can begin the process of budgeting and saving money that will be used to pay off your old debts, but to even begin you have to put an end to new ones.
Working with your creditors
If your debts have become too large, it may be time to come clean with your creditors and admit that you need their help. This is especially important since bankruptcy is no longer as easy a process since the Bankruptcy Reform Act of 2005. You may be forced to work out settlements with your creditors. Many will work with you as a way of getting paid back at least some of the money they loaned to you.
If that’s the route you must take, be prepared to negotiate everything. By everything, I mean payment schedules, payment amounts, principal balances and interest rates. See if you can get your creditors to reduce or eliminate your interest for a period of time, or to forgive a portion of your principal balances so that you have time to get on your feet and settle the rest.
Any agreements will have to be accepted by both you and the creditor in writing–never rely on verbal agreements or promises.
This will not be a pain free process. Your credit will be damaged (and reported as such) and you will not have access to further credit. But the payoff will be an end to collection calls and threats of judgments, garnishments or seizures, and a fighting chance to get back in control of your finances.
And once you get that control back, never give it up again.
Tushar @ Everything Finance says
It’s not credit itself that gets people in to debt, it’s how they use it. In fact, it can be great for your finances. If you can work it in a way that you can use credit and pay it off at the end of each period, thereby earning interest, you are good to go!
Hi Tushar–You’re making an excellent point. Unfortunately those who get in over their heads with debt aren’t in a position to do what you’re saying. You have to be master of your debt to implement that kind of strategy, and most people unfortunately aren’t in that position.