Canadian Finance Blog

Personal Finance Basics: Become Debt Free

Posted: 08 Feb 2012 02:00 AM PST

Personal finance can appear to be impossible. If you have a lot of debt, a modest income, and seem to not be making any progress towards rectifying either problem, then your financial problems may seem overwhelming. They don’t have to be. Personal finance really doesn’t need to be that difficult, regardless of your financial situation. If you’ve already started to spend less than you make, and if you have an emergency fund in place, then it’s time to become debt free. While not everyone has tons of debt pilled up, almost everyone is in debt to a certain amount. It may be a credit card that you’ve never really paid off since college, or it might be that car loan that you’re slowly paying down. It might be some student loans that have pilled up or it might just be your mortgage. Hardly anyone in our society is completely debt free, but that is what you want to become.

Becoming Debt Free

Why should you want to become debt free? A lot of people are perfectly happy living their entire lives in some form of debt. Personally, I want to become debt free because that frees up a lot of my income for other purposes. Or, as long as I stick to the plan of spending less than I make, I can reduce the number of hours that I would have to work in order to do so. When you’re in debt, you pay a daily amount of interest on all of the money that you owe – money that you need to earn in order to pay back that loan. If you didn’t have to pay back that money, you wouldn’t have to make it in the first place.

Paying Off Your Debt

So what’s the best way of paying off debt? Like almost everything else in personal finance, there’s lot of options and opinions. Some like the idea of a “debt snowball“, where you make minimum payments on all debts, and left over monthly money goes to the debt with the smallest balance. Once that debt is paid off, you re-purpose that minimum payment, alongside the leftover cash at the end of the month, towards the next small debt. This process continues until all debts are paid off. The pros of this method is that all of your debts will get paid, you will feel the sense of reward the quickest, and your monthly payments won’t shift much over the entire length of time you’re paying off that debt. The cons is that the smallest balanced debt may not be the highest interest debt, and potentially you could end up paying more overall than if you paid off the highest interest debt first – a second and also popular method. My preferred method is to make minimum payments on all debts, and make greater than minimum payments on one balance. I don’t like the idea of using all leftover money at the end of the month towards debt because I find it unsustainable. If I work hard and spend frugally, I want to be rewarded for my hard work, and not just see the money that I saved disappear. So instead I force myself to be good by setting up an automatic payment for greater than the minimum balance on a debt, ensuring that I am making good progress towards reducing my debt.

The second most important thing you can do towards becoming debt free is by making lump payments on your debts. My wife and I have done this recently. Basically what we did was when we came across some extra cash that we did want to put towards something, we put it aside in a separate bank account. This kept it from being accidentally spent from our main chequing account. We did this a couple of times, and eventually had a nice little lump sum sitting there. One day while going over our finances we realized that the lump sum was approximately equivalent to one of our debts. So we just paid it off, completely. In one fell swoop we erased another monthly payment with money that was just sitting around, waiting for a purpose. If you ever come across lump sums of money, put them towards your debt – especially if it pays the rest of the debt off. It’s an amazing feeling.

This personal finance “basic” will come at different points for different people. Some may not reach it until retirement, when they sell the house, pay off the rest of the mortgage, and move into their children’s house. Others may be free out of college, completely debt free because they took it slow and worked part time alongside their schooling, and have no intention of ever going into debt. As such, remember that personal finance is very, very personal, so set a goal for yourself when you want to become debt free, and start working towards it, one small payment at a time. The best thing you can do towards becoming debt free is simply start to move in the right direction, and then let the rest happen over time. As long as you’re spending less than you’re making, you will be well on your way to becoming debt free.

Are you debt free? When do you want to become debt free?

Personal Finance Basics: Become Debt Free originally appeared on Canadian Finance Blog on February 8, 2012.