Fabulous Financials

photo credit: danesparza

This is a guest post by Miranda Marquit, a blogger from All Business Personal Finance Corner.

$1 trillion. That’s how much American’s have amassed in revolving credit, according to the Federal Reserve. That’s a lot of debt. And if you feel as though you are drowning in debt, it can seem overwhelming to try and dig your way out of it. But having a plan for paying down debt can help.

Paying down debt as wealth building

One of the reasons paying down debt doesn’t always get top billing as an important priority is due to the fact that it just feels like you are spending more money. In order to change this, you need a new mind set. Realize that paying down debt is a wealth building tool. Debt - especially credit card debt - isn’t money that you have. It’s a loan against your future income. You’ll actually have more to spend in the long run if you get rid of your debt and live within your means. The New York Times offers this compelling illustration of the cost of debt:

For example, the typical American carries a $9,000 credit card balance from month to month. Say this card charges an annual 18 percent interest rate and allows paying as little as 2 percent of the balance each month. Even if no more charges are made on the card and the minimum payments is made on time every month, it would take 47 years to pay it off, according to the National Foundation of Credit Counselors. By then, total payments would be $32,994, including $23,994 in interest.

In the above scenario, you are paying $23,994 in interest - money that gets you anything in return and you have nothing to show for it. All interest charges represent is a payment for the privilege of putting money on your credit cards. Imagine what you could get with ~$24,000: a new car, contributions to your retirement account, a year of college (including living expenses), three or four family vacations. When you look at how much debt costs, getting rid of it becomes more important.

Prioritize your spending

In order to pay down debt, you need to free up some room in your budget. This means you need to take a good look at what you have been spending and decide what is most important. Bills, food, transportation to work and school and shelter are the essentials. You can also look at ways to reduce expenses in these necessary areas. Cook meals at home rather than order out. Use public transportation to get to work. Downgrade your cable package (or get rid of it altogether). Think about what you need, distinguishing those items from what you merely want. Make a list of your expenses, from most important to least important. You should also consider setting some money aside (even if it is a small amount) for savings.

You can also prioritize your wants. But make sure paying down your debt ranks ahead of your wants on your list of priorities. Figure out your budget based on your priority list. If you run out of money before you complete your list of priorities, it will be the least important things that are “sacrificed.”

Which debt to pay down first?

Next, you have to figure out which debts to pay off first. Most financial planning experts agree that you should pay off the highest interest, revolving debts first. Revolving debts are those that, like credit cards, allow you to continue borrowing money as you make payments - as long as you don’t exceed the limit the creditor sets for you. These debts are likely to cost you the most in the long run and should be paid off before you tackle the installment accounts (debt with usually fixed rates, like car loans, that you make regular payments on without adding to the balance).

Make a plan to pay off each debt, one at a time (while paying the minimum on the others) until it is paid off. List the lowest balance first or the highest interest rate first. The key is to create a plan and set priorities to pay off debt.

Miranda Marquit writes about personal finances for the All Business Personal Finance Corner and edits information on debt consolidation for DestroyDebt.com.