How To Get Out Of Debt: The Complete Guide To Debt

How to get out of debt

According to USA Today, the average American owes over $130,000 in debt but makes less than $60,000 a year.  With student loans costs skyrocketing, and income growing by less than 5% annually, it’s not hard to see why people struggle with learning how to get out of debt.  

To get out of debt, you need to both understand your debt and plan of attack for reducing it.  This guide will help you do that while also providing you information to better educate yourself on what your options are.  

What is debt?

Simply put, debt is money borrowed from someone else with an agreement to pay it back in the future. 

It’s a financial instrument; basically a reverse investment.  So why does it get such a bad rap?  Because it’s frequently misused, both intentionally and unintentionally.  The biggest issue is that it lets us buy stuff that we wouldn’t otherwise be able to afford. 

Let’s take a look at an example: the cost of financing a car

Example:  Cost of financing a car

Suppose you’re shopping for a car. You see one that you really like, but it’s $20,000. You don’t have anywhere near $20k, and it would take you years to save it.

But as luck has it, if you promise to pay $375 a month for 72 months, it’s yours today.  That seems doable, right?  

But It also means that over the life of the loan, you’ll pay $27,000 for a $20,000 car that is sinking like a rock in value. Too often we focus on the $375 a month, not on the fact that we’re paying 135% of the car’s value.

Anatomy Of Debt

The anatomy of debt

Debt basically consists of two parts.  The principal, which is the money you borrow, and the terms.   Don’t let that deceive you though, as there is a lot to know about those two parts.

Principal i.e. What’s borrowed

The foundation of all debt is the amount of money you borrow, called the “principal”. In our previous car example, the principal would be the $20,000 that you borrowed to purchase the car.  

how to get out of debt

That principal amount is what must be paid down in order for a loan to be paid in full and have your debt cleared. It’s also the amount that the conditions or “terms” of your loan are designed around.

Loan terms i.e. The fine print

When you borrow money, you are agreeing to a pre-established set of conditions that form a mutual understanding between the borrower and the lender. For lenders, it’s how they differentiate between the different loan products they offer.  

This includes things like:

  • How will the interest be calculated? Daily? Monthly? Compounding? By amortization schedule?
  • How is the minimum payment calculated and when is it due? Does it change or balloon over time?
  • What happens when you miss a due date? Is there a fee?  Does your interest rate change?
  • ​What happens if you overpay or pay off the loan early? Is there a penalty?
  • Does overpayment go towards principal or does it go towards future payments?  

As you can imagine, there are a ton of ways to package these and what conditions you receive varies based upon things like your credit,  collateral, and history with the lender.

read the mice type

Read the fine print

I know it seems tedious, but you need to make sure you understand the terms and conditions when agreeing to take on any debt, whether it’s a credit card, a mortgage, or any other loan.  

Companies are legally obligated to explain all the conditions of your loan, but often the legalese makes it difficult to follow what’s really going on, so most people just ignore it the way they would an iTunes license agreement.

Don’t Be Most People!

Even if you don’t read the terms and conditions, if you accept the loan, you accept them.  This means you will be subject to any additional fees or penalties detailed within them.

But what if you read them and it doesn’t make sense? Research them online and don’t borrow the money until you feel comfortable with what you are committing.

How payments works

Since there are so many variables that go into creating the terms of a loan, it’s critical that you 100% understand what your minimum payment consists of and how much of it applies to your principal.

Payments are calculated like this:

  • X % goes towards the principal
  • Y % goes towards interest accrued against the current balance
  • Z % goes towards fees e.g., origination fees, membership fees, late fees, payment processing fees, etc.

Let’s use a credit card bill as an example:

If you spend money on a credit card and pay off your total statement balance before your next due date, your full payment goes towards your principal. But if you only make the minimum payment, only a percentage will go towards principal–the remainder will go towards interest and fees.

Most people who use debt don’t pay off the entire balance, so they become subject to interest and fees.

Don’t be most people – Don’t borrow money unless you can pay off your entire balance before interest is charged.

Different types of debt

All debt is the same right?  Yes and No.  

There are all different kinds of debt, and knowing which is which will you empower you to make informed decisions on how you handle them.

Good debt vs. bad debt?

This can be a pretty contentious and subjective topic, so I’ll try to be diplomatic.   Debt is neither good nor bad.  It’s a financial agreement. 

A powerful one that can both cause you harm and provide a home and education for a better future.  As I said…it’s a bit subjective 

It’s often labeled as “bad” because folks can quickly find themselves in financial danger if they aren’t careful.  It’s very easy to find yourself paying back way more than you borrowed due to the interest that is charged.  

Some debt is good in that it enables you to acquire an asset (like a house, or your education) that generates enough ROI (Return on Investment) to offset the interest paid on the principal.

So yes, debt can provide leverage to acquire ROI positive assets that would otherwise be beyond your means. The important thing is to make an informed decision that you’re comfortable with.

Secured loans

Any debt that has an asset associated with it as collateral is considered to be a “secured” debt.  That collateral stands for the obligations of debt in the case you don’t pay it back. Typically, these debts will have lower interest rates than unsecured debt, since there is less risk on the part of the lender.

Examples: Car Loans, Home Equity Loans, Federal Student Loans

Unsecured loans

Unsecured debt is a loan with no collateral. For example, when you take out a personal loan, you’re not telling the company they can have something you own if you default. 

Now, this doesn’t mean they can’t pursue collections activities against you, it just means they can’t legally take a specific asset from you unless they go to court.  

One nuance here is that if you take out a personal loan from a company that you also bank with, they can look at taking money from your checking or savings account to stand for the debt.  Banks typically will try to work with the customer well before they do this, but just know it is a possible outcome.

Examples: Credit Cards, Personal Loans, Medical Bills, Utility Bills, Revolving Debt, Private Student Loans

Open-ended loans

Open-ended loans are revolving debt that can be reused as it’s paid back.  

Examples: Home equity loans, credit cards, lines of credit

How much debt is too much?

So much of success in personal finance involves learning a few meaningful tips and tactics and working to consistently apply them.  In this section, we’ll cover a few really helpful ones.

Debt-to-income ratio

Your debt-to-income ratio (DTI) is a simple personal finance ratio, that is calculated by taking your monthly debt payments and dividing it by your monthly income.

So, if you make $4000 a month and you owe $1000 a month in debt payments, your DTI is 25%. (Or, said another way: 25% of the money you bring in each month goes to paying the debt.)  

Your DTI ratio should be less than 43%

According to the Consumer Finance Protection Bureau, you should aim for a DTI that is less than 43%.

Why 43%?  According to the research, that’s the highest ratio someone can have and still qualify for a mortgage. So what do you do with that info?

  • If your DTI is higher than 43%, use it as a target.
  • If your DTI is already lower than 43%, be proud!

See if you can go even lower!

Your house payment should be less than 25% of your take-home

This is actually a recommendation that comes from personal finance personality Dave Ramsey. The point he makes is that if you keep it below 25% you won’t end up being house poor.  This means you’ll still have extra money to do other things, like pay off debt, enjoy life, and invest for your future.  

He also recommends getting a 15-year, fixed-rate mortgage. The reason for that is that these types of mortgages typically have the lowest interest rates, and the rate is locked, so you won’t have it jump up on you in 5 years.

Strategies for managing your debt

Learning how to get out of debt is hard.  There are no shortcuts,  so be wary when someone claims to have one.  That said, there are proven strategies that always work if you stick with them.  

Debt Reduction Strategies

The debt snowball 

With the debt snowball method, you will be paying down debt in order of smallest debt to largest debt, ignoring the interest rate or minimum monthly payment amount. I used the snowball method to pay down my own debt because I knew that I’d be more likely to stay motivated if I had some “quick wins” early on. Knocking out those small debts in the first few months provided a much-needed emotional and psychological boost.

Debt avalanche strategy

Using this approach, you will be paying down debt in order of highest to the lowest interest rate. This method may appeal to more the mathematically minded since you’ll likely pay less in interest over time, but you may have to wait longer to start seeing results.  

The remainder of this post will be focusing mostly on the debt snowball strategy, but if you’re interested in learning more, here’s a great resource for implementing the debt avalanche strategy.

debt snowball strategy

Debt consolidation

A debt consolidation program takes unsecured debts, and combines them into one loan, with one set of terms. The thought is that one loan, with one single set of terms, will be more favorable than a bunch of different loans with different terms.

But banks aren’t dumb, and they aren’t in the business of losing money. The single set of terms won’t be better than what you had, though they may be simpler to manage.   They usually offer a lower monthly payment, but that comes from extending the term of the loan.  This just means you’ll pay more interest over time.

While there is some benefit in that simplicity, you’re really just shuffling debt around and not addressing the problem.

Home equity loans

A Home Equity Loan (HELOC) is pretty straight forward. It’s just an open line of credit that is backed by your home. You are typically approved for an amount based upon a percentage of the equity you currently have in your home.

Because these loans are backed by your house, the APRs are typically lower than what you would get with a personal loan.

You’ve probably gathered that I’m pretty risk-averse when it comes to my family and our finances. The idea of borrowing additional money against our house just leaves a knot in my stomach.

It’s not that the product or the terms are particularly bad, it’s just a level of risk I’m personally not comfortable with. You need to understand and be true to your own appetite for risk.

Avoid debt settlement companies

The pitch is that if you work with them directly (for a fee) they will reach out to all of your creditors and negotiate a smaller settlement to the debt you owe.  

Sounds pretty good right?  So what magic do they have that you don’t? None.

Here’s what they do…

You pay them what you were going to pay the creditors.  They put those funds in an escrow account AFTER they take out fees. Because you are now NOT paying the creditors, your loans are going into default.  This is part of their plan.

Every lender has programs they offer to folks who are behind on their payments, to help either them get current or settle their outstanding debt for a percentage of what’s owed. The further you are behind, the larger that percentage maybe, but also the bigger the impact to your credit.  

Once you are far enough behind, the settlement company will call the lender and offer to settle the debt with some of what they have collected in their escrow account. Keep in mind, some lenders won’t even deal with them because they know they are ripping off the customer.  

What you should do instead…

If you are behind on your debt, and you have extra cash set aside to settle, call the lender directly.  No one is going to look out for your best interest better than YOU!

Different types of bankruptcy

Filing for bankruptcy is a huge decision that you shouldn’t take lightly since the impact will stay with you for a long time.  The emotions alone can overwhelm most people.  This chapter is designed to provide you a little more information about what it is and what you can expect.

Chapter 7 bankruptcy

This is when the court rules that some portion of your assets should be sold off, with the proceeds going towards your secured debts. Any debts not covered after that are dismissed outright by the court.

After that, you’ll need to prove that your income is not sufficient to enable you to repay your obligations.  This is often called a “means test,” and tends to disqualify a lot of people. In most cases, Chapter 7 filers are able to keep some of their assets.

The entire process for this lasts about three or four months, and you typically end up having a clean slate in regards to your finances.   

Chapter 13 bankruptcy

This is when you work through the court to establish a repayment plan with your creditors. You aren’t required to sell off your assets, but it can take several years to work through the proceedings. Eligibility is determined by your ability to make regular payments based on your net income.  

Filing for bankruptcy protection

Before you file for bankruptcy, there are a few things you should take into consideration first.

Not all debts can be discharged

Not all debts go away with bankruptcy. One surprising fact ab​​out student loans is that federally backed ones can’t be discharged.  Neither can outstanding taxes.

Often times, the only debts being discharged are unsecured debts like credit cards or personal loans. You’ll need to think through if those alone justify this extreme step.

The filing will be made public

Bankruptcies are court filings. Court filings are public record, which often ends up in the newspaper. That shouldn’t stop you, but it is something to be aware of when determining if filing for bankruptcy is right for your situation.  

It’s expensive

You’ll have to pay for your legal and court fees, which can add up over time. Make sure you are going in with eyes wide open here.  Most folks don’t have a lot of extra money at their disposal when filing for bankruptcy. 

Your credit is impacted for years

This will stay on your credit report for 7-10 years. That’ll impact you when borrowing money for a house, trying to rent, or even when applying for a job.

Many landlords, credit card companies, and prospective employers look at your credit score and report as a proxy to understand the stability and financial resilience of an individual.  

This doesn’t mean you won’t get offers for credit cards or auto loans. They just won’t have a 0% APR, or favorable balance transfer terms.  They likely will have the highest interest rate they can offer.

Should you file for bankruptcy?

​​​​This is a personal decision and one you should think hard about before pursuing. It’s not a reset button for your life. In many cases, you’re only going to be receiving relief against a handful of debts, while still having to pay off the others. 

If your debt is federally backed student loan debt or back taxes, bankruptcy isn’t a good option since it won’t address the problem.

If you have credit card debt, it may be a better option to talk directly with the creditor to work out a plan, since the lasting impacts will be much less and it may end up costing you less when you factor in legal fees.

What to do if you’re behind on debt

  1. Create a budget ASAP. You need to know where y​​our money is coming and going so you can make educated decisions.  Learning how to manage your cash flow is critical.
  2. Stop the bleeding. If you can make the minimum payments, make them! If you can’t, you need to triage your debts. I’m not advocating you don’t honor your legal obligations.  I’m saying you need to be pragmatic when the poop hits the fan.  Focus on taking care of the basics like shelter and transportation first. Then you work your budget and snowball accordingly.
  3. Communicate with your lenders. Let the lenders know what’s going on. Sometimes it will help. Sometimes it won’t. But if you borrowed money from them, you owe them some level of communication.
  4. Know your rights. The Fair Debt Collection Practices Act protects you against unfair collections practices. The FTC has a great summary of what these rights are and what they aren’t. I highly recommend you understand these, as they can help you deal with a very stressful situation.
  5. Own the problem. The worst thing you can do is to not address the problem. This isn’t something that gets better with age or goes away if you ignore it.
  6. Explore settling your debt. Once you’re in a stable situation, reach out to the creditor directly and make an offer. They will often settle for less than what you owe.  How much less depends on how much you owe, and how far behind you are. Just make sure you get your offer in writing or email and never provide them with access to your bank account.

How to get out of debt in six steps 

Find your motivation

How many times have you considered doing something good for yourself, but didn’t do it?  

  • “I need to start exercising and dieting.”
  • “I’m going to get out of debt.”
  • “I need to start saving money.”

Almost anybody could look at that list and find something that they agree should be a priority for them.  Yet most of us don’t do anything about it.

Not because we’re lazy. Not because we don’t care. But because they are just goals without any motivation behind them. You need to find the “why” that motivates you.

Stop borrowing money

Seriously.  Just stop.  You can’t fill in a hole and continue to dig one at the same time.

Create a resiliency fund

Prepare your personal finances to weather a storm with the first of two types of savings accounts you’ll eventually create, your resiliency fund and your emergency fund.  Your resiliency fund is a small amount of money, i.e. $750-$1k, that you’ll want to have in place while you’re still paying off debt.  It’s only intended to allow you to roll with the punches and maintain focus, not handle a long term emergency.  Once you’re out of debt, we’ll set up the long-term emergency fund.

Build a budget

I recommend creating a zero-based budget, which is a proactive monthly budget that you create prior to the start of the month.  When you make it you assign a job to each dollar until it equals zero.  You can even use categorized envelopes as a way to manage your budgeted cash. 

Other budgeting techniques tend to function more as after-the-fact shaming tools, enabling you to view all the damage you did during the previous month, at which point it’s too late to do anything about it.

The concept of zero-based budgeting has been around for years, and there are lots of good reasons that personal finance professionals recommend it.

Get organized and plan your strategy

  • List out your debts by balance, smallest to largest
  • Start rolling your snowball.  Make minimum payments on everything but the smallest.
  • Once the smallest debt is paid off, move on to the next smallest.
  • Rinse and repeat

Go all in

Military commanders throughout history have ordered their troops to set fire to the bridges and boats behind them as they move into enemy territory. They do this so they won’t have the option of retreat when it gets tough.

I love this concept as it relates to personal finance. Most people get into financial trouble by accumulating debt over time–a car loan here, a new credit card there, and next thing you know, you find yourself in the middle of a financial war zone.

You’ll never get debt-free if you fall back on these same habits each time life throws you a curveball.

Go all in and hit it hard! Freeze your credit cards, cancel your subscriptions, sell your car, stop dining out, no more vacations, sell anything you don’t LOVE! It won’t be fun, but it’s a short term pain. The point is to go as fast as you can to get your debt behind you.

Four ways to start today

Freeze a credit card: You can literally put your credit cards in a plastic container, fill it with water, and put it in the freezer.  This creates a little more friction for you if you want to use them. A lot of companies actually offer to do this virtually through their apps, so you can explore that as well. 

Cancel a subscription: Do you really need all the subscription services? Cancel one today. If it’s $10 a month, that will equal $120 more in your pocket over the course of the year.

Face the music: Get a dry erase marker and write down ALL of your debts, minimum payments, and due dates on a whiteboard or your bathroom mirror. Looking at this daily will make you more aware of where your money is going.

Turn off automated payments: Sometimes easy isn’t better.  I recommend you manually pay your bills when you’re working a debt plan.  It will force you to get better organized, and you won’t get surprised one morning when money gets withdrawn from your account you weren’t expecting.

Wrapping up

There is a ton of information to learn about how to get out debt so i’d recommend adding this article to your bookmarks for future reference.  If you’re looking for even more personal finance help on how to get out of debt or make money, here are a few other posts you should check out.

Leave a comment below and let me know what questions you have.

2 thoughts on “How To Get Out Of Debt: The Complete Guide To Debt”

  1. This article has the potential to be life changing for many people. We all struggle in one or more of these areas. It’s great to have a one stop shop for these needs. Keep up the good work!!

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