A few years back I was struggling to teach myself to manage money better. I made a decent living but was never satisfied with the rate at which I was paying off my school loans and other debt. I rarely had any money left over at the end of the month to save. I was living like millions of others: month-to-month. I tried various finance applications, read various books on the subject but nothing seemed to really help me get control of my finances. Then I came across one book in particular which changed the way I thought about budgeting and debt. More about that later.
My basic strategy was as follows:
- Write down all my monthly expenses, savings, assets, and debts
- Every payday withdraw cash for groceries, entertainment, and spending money: put into envelopes
- Build an emergency fund of $2,000 for unexpected things such as car repairs
- Finally, concentrate my extra money every month on debt, starting with the smallest balance
First write it all down. Then apply these three techniques: envelope system, emergency fund, snowball effect. This was a system I could wrap my head around.
To help me track my progress and keep me honest I created a spreadsheet with two sheets. The first sheet is where I document my budget: monthly expenses and what goes into each envelope.
Let your budget be somewhat fluid from month-to-month but try to stick to it for the month. In other words, don’t be afraid to change some numbers as things in your life change. If you find that you’re spending more on gas because you got a new job that’s a longer commute, increase that figure and reduce another. If your gas bill is particularly high one month increase your utilities allowance for that month and reduce another figure. But once you set the budget for the month, do your best to stick to it.
The envelope system really helps. I try to only use my debit card for gas at the pump. I do that simply because it’s convenient. I pay for groceries, going out to eat, movies, drinks, books, etc. with cash. Every pay-period I withdraw a certain amount of cash from an ATM and sort it into 3 envelopes: groceries, entertainment, spending cash. As I need it, I take some out and carry. But seeing the money in the envelopes provides tangible, physical feedback. You know exactly how much money you have left for the pay-period. You feel great when payday is in 2 days and you still have $150 in your envelopes. When you’re running low, put on the brakes. But you don’t have the temptation to just swipe that debit card every time you want some Starbucks, McDonalds, or that book. All those purchases add up over a month and you don’t really see it tangibly if you’re using a debit card.
On the second page of the spreadsheet I track my savings, debt, and net-worth. My strategy was not to save much beyond the $2,000 emergency fund until I was out of debt.
Like a snowball, your ability to pay off debt grows over time.
Remember to start with the smallest balance first while paying the minimum payment on every account. Once that smallest balance is paid off you’ll have a bit extra to work with every month. Proceed to the new smallest balance, and so on. Like a snowball, your ability to pay off debt grows over time.
I also graph my net-worth over time. After 5 or 6 months it’s a huge psychological boost to see the progress visually.
To really see it in action, you need to download the spreadsheet.
Excel format
OpenOffice format
All the numbers are fictional. Replace with your own. I’d love to hear feedback. Tell me what worked for you, what didn’t. Have any suggestions for improving the spreadsheet? email me at tips at wondr dot net
Oh, and about that book I mentioned that changed the way I looked at personal finance? The Total Money Makeover: A Proven Plan for Financial Fitness
Update: This post was featured in About Your Finances, The Carnival of Money, Growth, and Happiness, and The Carnival of Twenty Something Finances.
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I wasn’t sure how to start paying off debts. Recently bitten by the arrival of student loan payments, I decided that instead of paying off the smallest amount first, I would instead pay off the highest interest rate first. The idea behind this is to minimize the amount of interest I pay over time.
What do you think of this idea over the idea of paying off the smallest balance first? (Usually the two are not mutually exclusive since, at least for me, the interest rates are inversely proportional to the balance.) Is there any distinct disadvantage to taking my approach of which I should be informed?
Hey, Jared. The subject of whether to pay of the debt with the highest interest rate or the lowest balance is often debated, and your decision might be the right one for you. I could certainly imagine a situation where a person had two loans. Loan A is for $10,000 and has a 20% interest rate. Loan B is $9,000 and has a 5% interest rate. In that situation it seems like a no-brainer to pay off Loan A first since the balances aren’t all that different and the rate on loan A is much bigger than loan B.
The real reason that I argue for paying off the smallest debt first is that it keeps you from spreading your available money too thin. A lot of people have 3, 4, 5, or even more sources of debt between car payments, house payments, credit cards, medical bills, etc. Some of these may have fairly small balances, even under $1,000. If you only pay the minimum payment on those small balances and concentrate on your $20,000 car loan because it has a higher interest, you’ll be paying payments to all those sources of debt every month for a longer period of time. So that Visa card balance of $600 might take 6 years to pay off instead of a month or two.
Also, psychologically it does wonders for a person trying to get out of debt if they can knock one off the list. If your budget allows you $500 every month to pay down on debt and you can concentrate $400 on that Visa and $100 to pay your minimum balances on the rest, you’ll have the Visa paid off in 1 1/2 months and can forget about it. And you have more money to focus on the next balance since there are less minimum balances to pay every month.
You raised a great point, though. Thanks!
I agree on the psychological aspect, definitely. The last time a credit card was paid off, my wife and I just decided to concentrate all of our excess money on that one item and it was paid off in a month.
Luckily, though, unless one has a loan with an adjustable rate, or got in with a subprime lender or something equally disastrous, it seems that most debts do tend to line up with the small balance also having the largest interest rate.
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Great article. I started doing a spreadsheet about a year ago and it really helped me track things and organize my life.
I would definitely recommend going for the higher interest rate debt first. it’s simple dollars and cents/sense. if you can build an “interest payed” column into the spreadsheet to see how much you expend on interest each month, that will overcome any psychological barrier of the high interest vs. paying off balance.
Gabe: that’s a good idea. But I’m still an advocate of not spreading yourself too thin and using the snowball effect to build your ability to pay off more towards the debt you’re focused on over time. It has the added benefit of improving your credit by knocking off unpaid balances faster.
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