People get out of debt all the time, but they also tend to get back into debt eventually. In 2018, we conducted a nationwide survey that found 72% of people who budget say it’s helped them get out of debt in the past. But only 27% said it helped them stay debt free. Why is that?
If a budget is designed to help you achieve financial goals, then why can’t one of those goals be staying debt free? Can a budget help you stay out of debt once you achieve stability? We think it can. Here’s Debt.com’s step-by-step guide for how to stay out of debt using a simple household budget.
One last thing… it’s important to note that this is not a guide for avoiding debt entirely. We’re not against debt – we’re Debt.com, so debt is kind of our thing. We just believe people should debt responsibly. That’s what this guide teaches you how to do. Not so much how to stay out of debt, but really how to stay out of debt problems.
Table of Contents:
Step 1: Build your financial safety net
The number one thing that’s going to help you stay out of debt is money. You need something to use to cover all the things you’d normally use debt to cover. That means you need savings.
If you just got out of debt – whether you were facing challenges with credit cards or student loans or taxes or all of the above – you have an advantage here. You have money that was going to cover those debt payments that’s not being used for that anymore.
So, instead of spending or splurging, start saving. Take all the money you’re not using to cover debt payments and start putting it away for a rainy day.
Make savings into a recurring expense
Ideally, you want to save about 5-10% of your income in normal circumstances. But, if your goal is to stay debt-free and you just started saving, save as much as possible.
- Review your budget to determine how much you can afford to save each month.
- Write that down as a recurring fixed expense in your budget
- Then take the extra step of figuring out how much you can save out of each paycheck or which paycheck works better to add in a monthly amount you save.
- Finally, if possible, set up a recurring monthly transfer from your checking to a savings account.
Another option is to simply ask your HR department to split your Direct Deposit between your checking a savings account. Either way, you make saving money completely automatic.
Establish an emergency savings fund
If you’ve never had an emergency savings fund, start with a small reasonable goal. First, start with something like $1,000. That would cover most everyday unexpected expenses that always seem to come up. And even with limited income, on a well-balanced budget, you should be able to save up that much within a few months. This gives you a start goal to aim for.
Once you hit that goal, aim for $5,000. This will give you enough cushion to cover the most expensive car or home repairs. The more money you have to cover these unexpected expenses, the less likely you’ll be to slip into debt… even during a bad month when everything seems to break.
Rightsize it for unexpected life events
Covering most repairs and unexpected expenses is great, but eventually, you need an emergency fund that can cover even bigger unexpected life events. Namely, you need to be able to cover unemployment and illness.
This means you want to continue building your emergency fund to cover 3-6 months of budgeted expenses. The idea is that you could be out of work completely for a period of time without going into debt. You could effectively live off your savings.
With an emergency fund this size, you’ll enjoy a lot less financial stress over the unexpected. Getting fired, getting sick and being unable to work for a period of time, or just having the freedom to tell your boss you quit gives you true peace of mind.
Step 2: Learn how to stay out of credit card debt
If there’s one type of debt that’s all too easy to fall into, it’s credit card debt. Most people don’t fall off a credit card debt cliff. It’s usually a slow, but slippery descent into debt problems. So, if you’re going to stay out of debt then you need to follow the tips for staying out of credit card debt.
It’s worth noting that you can skip this step altogether by deciding not to use credit cards at all. However, they can be incredibly useful tools that can provide a lot of benefits. But you must be able to manage the debt. If you can’t, then swearing off credit cards may be the right choice.
Use credit cards strategically to replace necessary expenses in your budget
One of the easiest ways to use credit cards without creating a risk of debt problems is to replace expenses that are already in your budget. No, this doesn’t mean to substitute income that you don’t have. It means that you use a credit card to pay for an expense that you’d need to pay anyway. Then you use the money you save to pay off the balance every month.
This gives you the ability to use credit to earn rewards without taking on any debt. It works especially well for bills like utilities, groceries, and gas for your car. These are all expenses that many credit cards offer reward programs to cover.
Pay off most credit card balances in full every month
Your goal should always be to maintain zero net credit card debt. That means you pay off everything you charge every month. You basically start and end every billing cycle with a zero balance.
Want to know the great thing about this strategy? You use all your credit cards interest-free. As long as you start a billing cycle at zero and pay off everything you charge at the end of the month, interest charges never apply.
You constantly build positive credit card history, you keep your total credit card debt near zero and you earn rewards. It’s the ideal place to be in the credit world.
Save in advance to pay off big charges quickly
Let’s say you have a credit card that offers cash-back on electronics purchases. You know you need a new laptop, so you want to earn the rewards on the purchase. What you want to do is save up for the purchase in advance so you can pay off the balance immediately. That way, you don’t offset the cash back you earn with interest charges.
Be aware that it takes about 2-3 billing cycles for interest charges to completely eclipse the rewards you earn. So, paying off the balance as fast as possible is key if you want to earn instead of paying out.
If you start carrying a balance, stop charging and pay it off
Credit card balances happen. Even with good planning, you may have an expensive month or need to make an unplanned big purchase. In this case, you’ll generate a balance that would carry over from month to month. You want to avoid allowing these balances to linger. Otherwise, you can begin a slow, gradual descent into debt.
So, if you start to carry balances, stop charging and make a plan to pay off your debt. At a minimum, you should implement a debt reduction plan. You can also call your creditors to negotiate lower interest rates or consider balance transfers. These solutions will help you minimize interest charges so you can get out of debt faster.
Step 3: Minimize auto loans and auto-related credit card debt
Transportation costs make up about 15-20% of the average household budget. While auto loans aren’t typically a big source of debt problems, expensive auto repairs are a common cause of credit card debt. So, it’s important to use your budget to manage auto loan debt and avoid credit card debt down the road.
A larger down payment means less debt to pay off
Although no-money-down dealership offers may seem like a great bargain, they’re usually more expensive in the long run. You end up with higher monthly payments and higher total interest charges just to save a few bucks upfront. By planning ahead to save up for a large down payment, you can keep both monthly and total costs lower.
It’s also worth noting that, in general, loans that you get through an auto dealership will consistently be more expensive overall. You’re usually better off going through your bank, credit union, or preferred lender. Just like with a mortgage, you should shop for your auto loan first before you shop for the vehicle. This will help you see how much car you can afford and give you something to compare all those incentivized dealership offers.
Another key thing to note is that you can shop around for auto loans without causing any damage to your credit score. All credit applications for an auto loan made within a certain period of time (usually 14 days according to Experian) will count as a single credit inquiry. That means you can get real rates, as well as compare payments and total costs without hurting your credit score.
Don’t be lured into a long-term auto loan
Another way to minimize monthly auto loan costs is to opt for a longer-term loan. However, it’s critical to realize that long-term auto loans aren’t usually the best value either. A longer term means more months to apply interest charges. Thus, it increases your total cost.
You also need to consider how fast most cars depreciate in value. Most vehicles lose value the minute you drive off the lot. If you opt for a 6 or 7-year auto loan term, then you want to trade in your car after five years, you’ll still have a balance left to pay. That means not only will you not get money on the trade-in. You could be stuck paying off the deficiency. Long-term auto loans also tend to have higher rates of default.
So, it’s generally a good decision to opt for the shortest term possible. Use your budget to assess what monthly payments you can afford. Aim for the highest payment possible that you can comfortably afford without creating financial stress. This will help ensure you get out of auto loan debt quickly with the lowest costs possible.
Once you pay off the loan, divert the payment into savings
Extended warranties aren’t necessary and are usually just a cost drain. But even without an extended warranty, there are steps you can take to ensure auto repairs don’t turn into credit card debt. The easiest way is to devote part of your emergency savings fund to auto repairs.
A good way to generate the cushion you need is to divert funds into savings once you pay off your auto loan. You take the money you were paying towards your loan and put that full amount into savings every month. Invariably, cars tend to start breaking down right around the time you pay off your loan and the dealership warranty runs out. By increasing your savings once you pay off the loan, you can avoid credit card debt even if you need an expensive repair like replacing the transmission.
The other advantage of this strategy is that it helps you generate a bigger down payment for your next vehicle purchase. Once you’re ready for a new set of wheels, you’ll have all the money you’ve been saving to make the purchase without taking on an auto loan debt that will be a burden.
Step 4: Understand that even good debt can go awry
Credit card debt and even auto loan debt are considered “bad debt.” That’s because you don’t gain anything of value from taking out the financing (again, vehicles depreciate quickly). But there are two types of debt that are considered good debt:
Mortgages are good debt because you get an asset that usually increases in value over time. Student loans are considered good debt because the degree you earn increases your lifetime earning potential.
But just because a debt is good, it doesn’t mean that it’s good for your budget! Even good debt can go bad if you don’t manage it properly.
Protect the equity in your home! Don’t just borrow against it just because it’s there
Unless they face something like unemployment or a death in the family, most people don’t struggle with a first mortgage in normal circumstances. Especially following the mortgage crisis of 2008, lenders are extremely careful about making sure that a homebuyer will be able to afford their loan.
Where most people get into trouble with mortgage debt is when they borrow against their equity. Equity is the value of a home minus the remaining balance on the mortgage. You can borrow against this equity through tools like home equity loans, Home Equity Lines of Credit (HELOCs), and cash-out refinancing.
Although these mortgage tools can be useful for getting significant amounts of extra cash, they also increase your risk of foreclosure. Taking out a second or even third mortgage – which is what happens when you borrow against equity – increases your risk of foreclosure significantly. If you fall behind on the payments, the lender can start a foreclosure action. This is especially risky with HELOCs because of the payments balloon after 10 years.
Even a cash-out refinance can be risky. You borrow against the current higher value of your home. But if the market takes a turn, you can wind up with a mortgage that’s upside down. That’s when you owe more than the home is actually worth.
This is why you need to be very careful when considering tapping the equity in your home. For example, using equity can seem like a good option to consolidate credit card debt. You can get a much lower interest rate. But most experts will tell you that it’s not worth the risk!
Avoid student loans, but if you can’t then become an expert at repayment
Student debt is now the second largest source of debt in the U.S. after mortgage debt. Americans have one and a half times the amount of debt in student loans that they have on credit cards. Student loans also have the highest rates of default than any other type of traditional debt. There’s currently a 90-day default rate of 11.2% on student loans. By comparison, the default rate on credit cards is just 2.54%.
The best thing you can do to manage student loan debt is to avoid it completely. You want to borrow as little as possible, whether you’re the one going back to school or you’re helping your kids earn a degree. This means putting in work to find smart ways to avoid taking out student loans for school:
- See if your employer offers any benefits to pay for ongoing education
- Apply for as many scholarships as possible
- Look for grants and get good grades to earn grants once you start school
If you need to take out loans, then subsidized federal student loans tend to be the most cost-effective option. With a subsidized loan, the government covers interest charges that accrue while you attend school, as well as during deferment. This helps keep the amount you need to repay low once you graduate. Just be aware that qualification for subsidized federal loans is based on need and income.
Whether you take out subsidized or unsubsidized federal loans or even private loans, you need to become an expert at loan repayment. Before you get even close to graduation, you should understand when repayment starts, how penalties and interest charges apply, and solutions you can use for faster, more cost-effective repayment, such as debt consolidation and student loan forgiveness. That way, when you graduate, you won’t have to rely on spotty communication with the lender to know what your best options are for repayment.
More Smart Ways to Avoid Debt Problems
Know when it’s the right time to make extra payments
This tip specifically deals with loans. Oftentimes people are happy to just make all their installment payments on time as scheduled. But there can be a good reason to make extra payments on some loans.
Extra payments are payments made outside of the set payment schedule. You already made a payment this month and your next payment is not due yet. But you make an extra payment in between. If you do this, then 100% of the extra payment you make eliminates principal debt. That’s the debt you actually owe, as opposed to interest charges.
For many loans, this can be extremely invaluable. If you eliminate a bill, then you free up cash that you can use for other things. But you must be smart about extra payments.
- First, you should never focus solely on paying off debt. Don’t delay picking up another CD or making a stock investment until you’re completely debt-free. This is a good way to ensure you never save or invest.
- A good way to decide if you should save or pay off debt is to compare interest rates. If the savings or investment tool has a faster rate of return than the interest charges you pay on the debt then you may be better off opting to save instead.
- You should also make sure that there are no early repayment or prepayment penalties on the loan. If there are, then you’re doing more harm than good by deviating from the set payment schedule.
Using this reasoning, it often makes sense to make extra payments on personal loans, auto loans, and student loans. It makes less sense to do so on a long-term loan like a mortgage.
Always check the total cost of special financing offers
We mentioned in the section about auto loans that dealership financing is often more expensive. This logic applies to most loan offers you see. You often pay later for the financing incentives that you get now.
With any loan agreement, always make sure to review your Truth in Lending Disclosure Statement carefully. The Truth in Lending Act (TILA) protects borrowers from unfair lending practices. And one of the ways it does that is by requiring lenders to provide the Truth in Lending Disclosure. This is a form that you should receive from a lender detailing all the costs. Review it carefully before you sign the final loan agreement!
The disclosure should outline:
- The total amount financed by the loan
- APR (annual percentage rate)
- Total finance charges – i.e. how much you’ll pay to borrow the money
- The monthly payment requirement
- Total number of payments
- How penalties can be applied, like those from late payments or extra payments
And remember, with auto loans, mortgages and student loans, multiple loan applications within a certain time frame will only count as one credit inquiry. This allows you to shop around and compare the exact rates and terms to find the best loan. A good rule of thumb is to get all applications done within a 2-week timespan.
Please note that this does not apply to personal loan applications. So, if you apply for a personal loan or consolidation loan, you can request quotes from multiple lenders, but you should only apply for one!
Avoid fees whenever possible
Fees are not your friends! You want to avoid them whenever possible. This means you should:
- Steer clear of loans with early repayment penalty fees
- Look for refinancing that drops loan origination fees
- Avoid credit cards with high annual fees
One that last one, it’s worth noting that credit cards with annual fees tend to have the most attractive cardmember benefits. There are cards that offer insane rewards programs, but you pay a few hundred dollars every year to use the card. In order to make the card worth the fee, you usually must use it a lot and spend big. You should only do this if you have the means to afford to manage that much debt. Otherwise, this is a recipe for debt disaster!
Never be satisfied with your interest rates
We’re not recommending that you go through a continual cycle of refinancing. That can lead to fees that we just told you to avoid, as well as too many inquiries on your credit report. But you should always keep attaining lower interest rates in the back of your mind.
These are some good times to refinance or – in the case of credit cards – negotiate lower interest rates:
- If your credit score has improved since you opened the credit line
- When the Federal Reserve reduces benchmark interest rates in a weak economy
- With credit cards, you can use patience with customer service screw-ups or billing issues on their end as a reason to request a rate reduction
Read all contracts, agreements and statements… or find someone who can
Nobody likes to read contracts and loan agreements. They’re not exactly written in simple language. But ignoring them can lead to trouble once you’re in repayment. If you don’t feel comfortable reading your loan agreement, then find someone close to you that you can trust to help you. If all else fails, you can consult a lawyer. This is the main reason that people hire real estate attorneys when buying a home.
You should also take time to read your monthly statements, particularly on your credit cards. These statements show you your current rates (which are subject to change on most cards), as well as total interest charges you’ll pay on your current balance. Also, be aware that statements may include notices of rate increases, so it’s crucial not too just ignore this information.
Remember that Debt.com is here for you!
If you follow the advice above, then you hopefully won’t need many of the debt solutions we offer, although we can help with things like consolidation and refinancing. We also offer credit resources that can help you achieve an excellent credit score.
If you do ever end up facing challenges with debt again, remember that we’re here to help!
Article last modified on June 23, 2022. Published by Debt.com, LLC