How to become Debt Free: A Step-by-step Guide
Posted on November 10, 2020 in Debt
Feel like you’re drowning in debt? Wondering what the best way to reduce debt is? View our comprehensive debt elimination guide below, and let our financial experts help you find the right program to pay off your debts responsibly.
The first step Towards Debt Elimination is to take control
Just because you find yourself in debt now, that does not mean that there is not a way out. Nobody wants to have to worry about being in debt, and it can be exhausting to feel like you are stuck in a perpetual cycle where debt is in control of your life. Take charge of your debt today by following our guide on debt elimination and how to become debt free.
Next, to become debt free you need to understand your spending
Ask yourself, “how much money do I spend each month?” Determining this is essential to understanding if you are spending more than you are earning each month.
Every month when you receive a paycheck it will go towards two main categories: fixed expenses, and variable expenses. A fixed expense is something guaranteed, like a minimum credit card payment, apartment rent, or a phone bill. On the other hand, variable expenses are costs such as pet expenses, personal care, shopping trips, or travel.
Once you have a good grasp on how much you spend vs. how much you take home, then you can move on to the next step.
The Third step to becoming debt free is to ask yourself: “Do I have too much Debt”
Now that you have a good handle on what your spending looks like, you need to start determining if you have too much debt. A debt calculator can be a helpful tool to better understand if you have too much debt, but we have broken it down for you in two ways below that will make it easy to understand. First, we will help you figure out how to measure your debt burden, and then we’ll help you determine your total debt, both key factors for debt elimination.
You are probably wondering, “What is debt burden?” Essentially, your debt burden is the cost of servicing debt, or in other words, the ratio of how much of your paycheck goes towards paying off your debt. This is also called a debt burden ratio, which is a mathematical ratio that takes into account how much of your monthly income is allotted to servicing your monthly debt. A quick and easy way to calculate this is to take your monthly debt payments and divide that figure by your monthly pre-taxable (gross) income. For example, let’s say you pay $750 per month in debt payments, and you take home $1,500 each month in gross income – when you divide 750 by 1,500 this comes out to a debt burden of 50%. Another way to say this is that 50% of your income is devoted to debt, and the goal is to get this debt burden ratio down to below 36 percent of your income in order to more easily eliminate your debt. A debt settlement option can be worth it to help lower this percentage. Now that you have a good hold on your debt burden, we will explore the second key part of determining if you have too much debt, which involves understanding your total debt.
If debt burden represents how much of your individual paychecks are consumed by debt payments, total debt takes a larger perspective, encompassing “the big picture.” Also known as debt-to-income (DTI), total debt compares all of your unsecured debt obligations to your annual income. In an ideal scenario, you are going to want your unsecured debt to be less than half (<50%) of what you make in a given year.
Unsecured debt does not have any collateral, which means that borrowers do not have to worry about risking personal assets such as property as this type of debt is not protected by a guarantor. The most noteworthy examples include credit card debt, utility bills, medical bills, and student loans. Each of these instances factor into total debt.
On the other side of the coin we have secured debt, which is a type of debt that is backed by collateral or a pledge of assets. For example, when borrowing money to buy a tangible asset like a home or car, a secured debt loan is necessary in case you do not repay that debt. This means that the lender or bank will be able to seize the collateral (house or vehicle) and sell it in order to use the proceeds to pay back the debt. This reduces the risk associated for the lender and will not count towards your total debt.
With those two kinds of debt now in mind, let’s look at an example that illustrates how total debt works. The equation is quite simple; all you have to do is take your total amount owed on unsecured debt (medical bills, student loans, full credit card balances, etc.), and divide that figure by your gross (pre-taxable) annual income. For example, say you have $25,000 in unsecured debt, and you make $45,000 – when you divide 25,000 by 45,000 this comes out to a total debt percentage of 55%. This number indicates the there is a cause for concern, as the goal is to have a total debt figure where your unsecured debt is less than half of your annual gross income.
At this point you should have a pretty strong grasp on where you are financially, but the final piece we need to establish is your credit score.
The last step towards living debt free involves asking yourself “What is My Credit Score?”
Your credit score is one of the most crucial indicators of your overall debt health and provides lenders an important look back into your past credit behavior and practices. To understand your credit score and how it plays into debt elimination, let’s take a look at key factors that help lenders evaluate how risky it may be to lend you money.
- Payment History and Missed Payment – Consistently paying creditors on time is the most important factor in determining your credit score. Missing just one payment can have a negative effect, and that’s why payment history makes up about 35% of your FICO score.
- Revolving Utilization – Your revolving utilization is determined by your total balance owed on your revolving accounts compared to your total credit line. In other words, it’s the percentage owed relative to your total credit. The amount you owe lenders is the second most important factor that impacts your credit score and makes up about 30% of your FICO score.
- Length/age of Credit – In general, the longer your credit history is, the better. This piece of your credit score makes up roughly 15% of your credit score, and includes the age of your oldest credit account, the age of your newest credit account, as well as the average age of all your credit accounts.
- Credit Inquiries – When you apply for a new credit card or loan, lenders do a hard inquiry. In general, you don’t want too much credit seeking activities (inquiries), in a short period of time. Thus, fewer credit pulls usually equate to a good indicator for lenders, with this piece of your score making up about 10% of your total credit score.
- Total accounts – Your credit score will consider the different types of credit being used and reported such as revolving credit and installment loans. Creditors would like to see that you can responsibly manage a mix of credit types, which is why this portion of your score makes up about 10%.
You’re entitled to a free copy of your credit score every 12 months from each of the three nationwide credit bureaus, and there are several other ways to access your score for free throughout the year. After you receive your credit score, you may still be wondering, “What is a good credit score?” We’ve broken that question down for you below, as this score will help you determine how easy it will be to eliminate debt. The higher the score, the more quickly and easily it will be to become debt free.
A credit score is a three-digit number that can typically range between 300 and 850. The three main score ranges are as follows:
- 300-669: Poor/Fair – If your credit score falls in this range it means you still have options for getting out of debt, but you’ll need to put in some extra work and effort.
- 670-739: Good – This is an ideal range to have your credit score fall into, and there are many more debt relief strategies available to you that will help you pay off your debt.
- 740-850: Very Good/Excellent – This is the top percentile of credit scores, and range to strive for in the long term. If you have a score like this, you are likely to receive some of the best rates from lenders, which will help you pay off your debt faster and at a lower cost.
Regardless of where your credit falls on the scale, there are debt elimination options for everyone. Get in touch today and let our financial experts help you take the first step towards eliminating your debt and taking control in becoming debt free.
Also be sure to check out our current free debt webinar: How to Pay Off Credit Card Debt Fast
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