These times are hard and it is getting even harder because of the ongoing financial crisis. In the last ten or so months alone a lot of people have gone under debt because of the financial crisis created by the Coronavirus situation.
Being under debt is a heavy burden that one should try to get rid of as soon as possible. It is however not always possible for people to make it out of debt successfully without damaging their credit score. This happens because most people simply do not have the required knowledge of personal financial management.
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What is Personal Financial Management?
Personal financial management involves knowing how to manage, save, spend and invest the money in an efficient manner. Personal financial management should ideally be taught at schools from an early age so that students grow up learning good personal financial management habits. This, however, is an area that is neglected by our educational system. Luckily there are a lot of personal financial management applications available to help manage the finances.
Importance of Personal Financial Management for Debt Reduction
The importance of personal financial management increases many folds when a person gets under debt. Indebtedness, as stated above is a heavy financial burden and therefore requires strategic planning. Awareness about good personal financial management habits can help many individuals manage their debts without damaging their credit scores by missing payments.
Steps on getting out of Debt
As stated above, getting out of debt requires strategic planning. With proper planning, one can not only lessen the burden of debt but get out of it quickly. So let us look at a step by step approach that you can adopt to get out of debt.
1- Budgeting
Budgeting is the bedrock of good personal financial management. The moment you mention budgeting to someone, people start to frown because this word has been beaten down so much. There is however no other way to say it. Budgeting is a key process that sits at the foundation of financial management.
Have you ever seen a company function without a budget? Companies have multiple budgets that help them achieve their monthly and annual goals. Similarly, countries also need a budget to function properly. So why have we come to resist the concept of making proper budgets for our households?
Before the age of smartphone applications, making the budgets used to be a time-consuming task but now that there are dozens of applications, one can make their weekly and monthly budgets quite easily.
There are applications that can track your spending and give you insights on how to improve the spending and the savings rate. With a little time and effort, one can improve their savings and spending rate, which as you will read further, play a crucial part in getting out of debt.
Budgeting, therefore, is an essential step if you want to get out of debt.
2- Savings vs Spending
It is absolutely vital to work on these two rates. Your savings rate shows you how much you save on average. In the United States, the average savings rate hovers around 10% to 15% were at the peak of the Covid-19 lockdown in March, this rate peaked at over 30%.
An average family can easily save around 30-40% of their income without making drastic changes to their lifestyle. FIRE enthusiasts can save up to 60-65% but this requires commitment and a complete change in lifestyle.
The reason for increasing the savings rate is to create extra income that can be used to increase the debt repayments. They say that every penny saved is a penny earned and when you are in debt every penny saved is a penny repaid.
The spending rate also needs to be controlled. Reducing the spending rate requires financial discipline. This should ideally be done in phases so that you can get used to the change in your spending habits. Try to start by reducing all unnecessary expenditures at first. Try to look for discounts and sales, look for cheaper alternatives to the products you buy. Are you paying for cable tv subscription, streaming services and internet? Why not get rid of cable tv subscription and switch to streaming services.
This will depend a lot on your personal preferences, habits, likes and dislikes. There cannot be a one size fits all strategy here. The aim should be to reduce the level of spending gradually so that you can have as many savings as possible.
3- Create multiple income streams
This is one of the most important steps of getting out of debt. If you have a single active source of income such as a 9-5 job, then you will struggle to get out of debt. This is where many people get stuck and when they start to feel the financial strain, they try to look for a second job.
The idea is to not leave it till its too late. Try to create multiple income streams as soon as possible. Covid-19 has been tough on many but it has also changed a lot, one such thing has been the rise of freelancing. If you have a day job, you can use your skills to freelance from home when not at work and on weekends.
If you do not have time to freelance, then try to create a passive income stream. There are numerous ways of creating passive income streams. Passive income streams do not require a lot of investment of time and energy. If done right, passive income streams can turn out to be very rewarding.
Creating multiple income streams is going to give you that extra financial cushion, you can use the extra income to pay off the debt quickly and also keep aside some savings and invest them.
4- Invest the savings
Investing savings is a critical step. Many people tend to ignore it when they are in debt but investing your savings is a step that should never be ignored. Yes, when you are under debt the opportunity cost of investment is the increased repayments. But this opportunity cost is worth it because whatever you save and invest today, will multiply and become your financial cushion in the future. You never know what the future holds for you, therefore it is important to prepare for the future while trying to improve the present.
So, this was the step by step guide on how to get out of debt. By following these four steps, you can improve your personal finances and set yourself on a path of becoming free of debt.
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