People get out of debt all the time, but they also tend to get back into debt eventually. In 2018, debt.com conducted a survey in the US that found 72% of people who budget say it’s helped them get out of debt in the past. Only 27% said it helped them stay debt free.

A budget is designed to help you achieve your financial goals. Here’s a step-by-step guide on how to stay out of debt using a simple household budget.

Step 1: Build your financial safety net

Make sure you have enough savings to stay afloat. Money is the number one thing that’s going to help you stay out of debt. You need savings to cover all the things you’d normally use debt to cover.

If you just got out of debt, you have an advantage here. You now have money that was going to cover those debt payments that’s not being used for that anymore. Start saving instead of spending or splurging. Use all the money you’re not using to cover debt payments and start putting it away for a rainy day.

Make savings a recurring expense

In normal circumstances, you want to save about 5-10% of your income. But, if your goal is to stay debt-free and you just started saving, save as much as possible.

1. Review your budget to determine how much you can afford to save each month.
2. Write that down as a recurring fixed expense in your budget
3. Then take the extra step of figuring out how much you can save out of each paycheck or which paycheck the savings comes out of.
4. If possible, set up a recurring monthly transfer into your savings account.

Start an emergency savings fund

Start with a small reasonable goal that would cover most everyday unexpected expenses that always seem to come up. This gives you an objective to aim for.

Once you hit that goal, aim higher. Having money to cover these unexpected expenses cushions you from slipping into debt, even during a bad month when everything seems to break.

Rightsize your emergency savings fund for unexpected life events

You need an emergency fund that can cover even bigger unexpected life events, for example, unemployment and illness.

This means you have to continue building your emergency fund to cover 3-6 months of budgeted expenses. An emergency fund this size allows you to enjoy a lot less financial stress over the unexpected.

Step 2: 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. Credit card debt is usually a slow and slippery descent into debt problems. You need to stay out of credit card debt to be debt-free.

You can also decide not to use credit cards at all.

Use credit cards to replace necessary expenses in your budget

One of the ways to use credit cards without creating a risk of debt problems is to replace expenses that are already in your budget. Note, this doesn’t mean to substitute income that you don’t have. This 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 clear the balance every month.

This enables you to use credit to earn rewards without taking on any debt. This works 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 credit card balances in-full every month

Your goal should always be to maintain zero net credit card debt, meaning you pay off everything you charge every month.

The good thing about this strategy is you use all your credit cards interest-free. Interest charges don’t apply if you start a billing cycle at zero and pay off everything you charge at the end of the month.

You increasingly build positive credit card history, keep your total credit card debt near zero and you earn rewards. It’s the best place to be in the credit world.

Save in advance to pay off big credit card charges quickly

Let’s say you have a credit card that offers cash-back on electronics purchases. You’re in need of a new laptop, so you want to earn the rewards on the purchase. The best thing to do is save up for the purchase in advance so you can pay off the balance immediately.

It takes 2-3 billing cycles for interest charges to completely eclipse the rewards you earn. So, paying off the balance as fast as possible is essential 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 may arise to make an unplanned big purchase. In this case, you’ll create 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 descent into debt.

If you start to carry balances, stop charging and make a plan to pay off your debt. You can also contact your creditors to negotiate lower interest rates or consider balance transfers. These strategies 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 are 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. It’s very important to use your budget to manage auto loan debt and avoid credit card debt down the road.

A larger down payment leaves less debt to pay off

Although no-money-down dealership offers may seem like a good 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 little cash up front. Planning ahead to save up for a large down payment helps you keep both monthly and total costs lower.

In general, loans offered through an auto dealership will consistently be more expensive overall. It’s better going through your bank, credit union or preferred lender. Also, shop for your auto loan first before you shop for the vehicle. This will help you determine how much car you can afford and give you something to compare all those incentivized dealership offers.

Note, 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 will count as a single credit inquiry. That makes it possible to get real rates, as well as compare payments and total cost without hurting your credit score.

Don’t be enticed 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 important to realize that long-term auto loans aren’t usually the best value either. A longer term loan means more months to apply interest charges, increasing your total cost.

Another thing to consider is how fast most cars depreciate in value. Most vehicles lose value the minute you drive off the off. That means if you select 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 you will not get money on the trade-in and you could be left paying off the deficiency.  Also, long-term auto loans tend to have higher rates of default.

Therefore, it’s ideal to opt for the shortest term possible. Opt for the highest payment possible that you can comfortably afford without creating financial stress. This will help you get out of auto loan debt quickly with the lowest costs possible.

Once you pay off the loan, direct the payment into savings

Extended warranties aren’t a necessity. Without an extended warranty, you can devote part of your emergency savings fund to auto repairs to ensure auto repairs don’t turn into credit card debt.

The best way to generate the cushion you need is to divert funds into savings once you pay off your auto loan. Ensure you put the full amount you were paying towards the loan into savings every month.

This strategy also helps you generate a bigger down payment for your next vehicle purchase. Once you’re ready to purchase a new car, you’ll have all the money you’ve been saving to make the purchase without taking on an auto loan debt.

Step 4: Understand that even good debt can turn into bad debt

Credit card debt and auto loan debt are considered to be bad debt because you don’t gain anything of value from taking out the financing . But there are two types of debt that are considered good debt:

1. Mortgages
2. Student loans

Mortgages are considered good debt because you get an asset that usually increases in value over time. Student loans are good debt because the degree you earn increases your lifetime earning potential.

Remember, just because a debt is good, it doesn’t mean that it’s good for your budget. Even good debt can turn into bad debt if you don’t manage it properly.

Protect the equity in your home

After the mortgage crisis of 2008, lenders are extremely careful about making sure that a homebuyer will be able to afford their loan.

Most people get into trouble with mortgage debt when they borrow against their equity. Equity is the value of a home less the remaining balance on the mortgage.

Mortgage tools also increase your risk of foreclosure. Taking out a second or even third mortgage increases your risk of foreclosure significantly. If you’re not able to make your payments, the lender can start a foreclosure action.

 Avoid student loans, but if you can’t then become an expert at repayment

The best thing you can do to manage student loan debt is to avoid it completely. Ensure to borrow as little as possible, whether you’re the one going back to school or you’re helping your kids earn a degree. You therefore need to find smart ways to avoid taking out student loans for school.

If you have to take a loan, subsidized federal student loans tend to be the most cost-effective option.

Whichever type of loan you take out you need to become an expert at loan repayment. 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.

More Ways to Avoid Debt Problems

Know when it’s the right time to make extra payments

You can make extra payments on some loans. Extra payments are payments made outside of the outlined payment schedule. If make an extra payment, 100% of the extra payment you make eliminates principal debt.

For many loans, this can be extremely important. If you eliminate a bill, you free up cash that you can use for other things. But you must be smart about extra payments.

1. First, you should never focus primarily on paying off debt. Don’t delay making an investment until you’re completely debt-free. This is a good way to ensure you never save or invest.
2. Compare interest rates to decide if you should save or pay off debt. 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.
3. You should also make sure that there are no early repayment or pre-payment penalties on the loan. If there are, then you’re doing more harm than good by not following the set payment schedule.

Using this reasoning, it often makes sense to make extra payments on personal loans, auto loans, and student loans. However, it makes less sense to do so on a long-term loan like a mortgage.

Always check the total cost of special financing offers

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. TILA requires lenders to provide the Truth in Lending Disclosure which is a form that you should receive from a lender detailing all the costs. Read it carefully before signing the final loan agreement.

The disclosure should outline:

1. The total amount financed by the loan
2. APR (annual percentage rate)
3. Total finance charges, i.e., how much you’ll pay to borrow the money
4. The monthly payment requirement
5. Total number of payments
6. How penalties are applied, like those from late payments or extra payments

And remember, with auto loans, mortgages and student loans, several loan applications within a certain time frame will only count as one credit inquiry. This allows you to look around and compare the exact rates and terms to find the best loan.

Please note that this does not apply to personal loan applications. If you apply for a personal 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:

• Avoid loans with early repayment penalty fees
• Look for refinancing that drops loan origination fees
• Avoid credit cards with high annual fees

Never be satisfied with your interest rates

I’m not recommending that you go through a continual cycle of refinancing. That can lead to fees that I just told you to avoid, as well as too many inquiries on your credit report. Remember, the goal is to attain lower interest rates.

Read all contracts, agreements and statements or find someone who can

Ignoring loan agreements can lead to trouble once you’re in repayment. If you’re not comfortable reading your loan agreement, find someone close to you that you can trust to help you or consult a lawyer.

You should also take time to read your monthly statements, especially on your credit cards. The statements show you your current rates, as well as total interest charges you’ll pay on your current balance. Statements may also include notices of rate increases, so it’s crucial not to ignore them.

At Finstock Evarsity College, we offer an online course in Basics in Debt Management. The course provides an overview of debt and credit management by explaining concepts in a user-friendly language. Click on the link below to apply.

Basics in Debt Management (FRDM)