As I wrote last week, I recently distilled my many years of teaching people how to get out of debt and stay out of debt into a five-step system called Dump That Debt! My system is simple, easy to use, and highly effective. Best of all, anyone can use it to get out of credit-card debt, and, really, all debt, and the techniques it teaches can be applied to anyone — regardless of income, assets or the amount owed.
Unlike debt consolidation, which typically has an 80 percent-plus recidivism rate (more than 80 percent of the people who use debt consolidation loans end up back in debt), my system teaches the user to think about spending money in a new way. Once the user has incorporated my techniques into his or her daily life, they are able to reduce and eventually completely eliminate their debts, and, most important, stay out of debt permanently.
This week, I will discuss the next step in my five-step system: prioritization/elimination/reduction. Once you’ve created your budget, gathering all of your income and expenses, preferably for at least three months, and have included any quarterly or on-time annual expenses, etc., you need to separate your expenses into necessities and discretionary expenses (non-necessities).
Necessities are things you basically can’t do without, or at least can’t easily reduce or eliminate without a major disruption in your life — things like rent or a mortgage, food, utilities, fuel, insurance, etc. Discretionary expenses are those items that you buy each month and throughout the year that you don’t really need, but you want and like.
Once you have separated your necessities from your discretionary expenses, you will need to prioritize them — placint them in order from your least important expense to your most important expense. Do this for your necessities and for your discretionary expenses separately.
This process has two purposes. First, it forces you to think through each expense to decide if the expense is a true necessity or a discretionary item. One person’s definition of a necessity can differ from another’s. Second, it sets up the process of eliminating or reducing your spending by placing the expense that is the least important to you first, at the top, with the expenses increasing in importance as you move down the list.
After you have your expenses prioritized, you will want to start evaluating each expense, starting with the first one in the discretionary expenses category. Often those at the top are smaller things, such as coffee, newspapers, magazines, cigarettes, etc. These small items are very important because they don’t seem like a big deal, but they add up over time. Let’s take coffee as an example. If you spend $3.50 a day, five days a week on coffee, you are spending $17.50 a week, $70 per month, $840 a year, $4,200 in five years and $8,400 over 10 years.
The focus of this process is to go down the list to see which expenses you can eliminate. Maybe, if coffee is on the list, you can make it at home, or grab a cup at the office. If cigarettes are on this list, maybe this is the time to quit, and having the added incentive of getting out of debt can help you stick to it!
Work through each expense in the discretionary category and determine which, if any, you can eliminate. Since these are all non-necessities, it should not be that difficult to cut out some of these completely.
If you evaluate an expense, but you don’t think you can completely eliminate it, consider reducing it. Maybe you can get a cup of coffee every other day. Or, if you drink more than one cup a day, maybe you can cut that back to just one. Go through each discretionary expense and try to eliminate or at least reduce each one. The ones at the top of the list will be easier to address, since you placed them in order from least important to most important.
Hopefully, after going through your list, you will find that you have extra cash left over each month. That extra cash is the key to getting out of debt! Any extra cash you have should be applied to your debt with the highest interest rate. Once that debt has been completely paid off, your extra cash should go to the next highest cost debt and so on.
If you find, after going through your discretionary expenses, that you still do not have enough extra cash left over each month to make an impact on your debt, you will need to use the prioritization/elimination/reduction strategy with your necessities. Things like rent or a mortgage are tough to reduce, but it can be done — move to a less expensive house or apartment. Combine trips or get a more fuel-efficient car. Go through your grocery list and reduce your food expenses. Get rid of cable TV. These are all tough things to do, but if you are deep in debt, and cutting discretionary expenses isn’t enough, you will have to take more drastic steps to get your financial house in order.
Regardless of how much you owe, there is a way for you to get back on your feet financially. Some will have to work harder and longer than others, but if you develop a sound plan and stick to it, you will eventually overcome the burden on debt. It is up to you to take the first step.
— Craig Allen, CFA, CFP, CIMA, is president of Montecito Private Asset Management LLC and founder of Dump Your Debt. He has been managing assets for foundations, corporations and high-net worth individuals for more than 20 years and is a Chartered Financial Analyst (CFA charter holder), a Certified Financial Planner (CFP) and holds the Certified Investment Management Analyst (CIMA) certification. He blogs at Finance With Craig Allen and can be contacted at craig@craigdallen.com or 805.898.1400. Click here for previous Craig Allen columns. Follow Craig on Twitter: @MPAMCraig.
