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How Debt Works


How to Get Out of Debt
The easiest way to get out of (and avoid) debt is to budget.
The easiest way to get out of (and avoid) debt is to budget.
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The simplest way to get out of debt -- and for many the most difficult -- is to budget your spending and save enough cash to pay off your debts.

A budget is a financial plan that allocates a specific amount of money to be spent on certain commodities like food, clothing, mortgage or rental payments, entertainment and savings. Here's how to use a budget to lower your overall debt:

  1. ­Carefully record your monthly spending -- down to every utility bill, pack of gum and newspaper. These are called your fixed expenses (phone and electric bills) and your variable expenses (double lattes and movie tickets). ­
  2. Figure out exa­ctly­ how much money you take home in income every month and subtract the cost of your fixed and variable expenses. What's left over is how much you can spend on lowering your debt.­
  3. You can increase your monthly budget surplus (the amount left over) by eliminating items from your variable expenses that are unnecessary or unnecessarily expensive.
  4. Make a list of all of your monthly debts along with the interest rates for each type of debt.
  5. Pay off the debt with the highest interest rate first, while continuing to make at least the minimum monthly payment on your other debts.

Debt consolidation is another way to reduce your debt load. Debt consolidation means taking out a lower-interest loan to pay for higher-interest debts. It's called consolidation because you take several high-interest debts and consolidate them under one lower-interest payment. It's not an ideal way of reducing debt, because you're technically incurring more debt to pay off the debt you already have.

Typical forms of debt consolidation are a home equity loan or a second mortgage. Second mortgages are like home equity loans in that they use the home as collateral and carry relatively low interest rates (although certainly higher than the original mortgage). An example of debt consolidation would be to take out a home equity loan to pay off credit card debt.

Credit counselors are trained professionals that can help a chronic debtor come up with a manageable budget, develop a "debt management plan" and even negotiate with creditors for lower interest rates or better loan terms. However, not all credit counseling services are legitimate. Some of them charge hidden fees, called "voluntary contributions," that can quickly get expensive. Others are able to win lower interest rates only after purposefully defaulting on all of your loans and ruining your credit score.

If you find yourself up to your neck in debt with no possible way out, there are two final options: debt settlement and bankruptcy. Debt settlement is an arrangement between a debtor and a borrower to pay one lump sum to satisfy the debt rather than monthly payments that incur interest. This lump sum is typically less than the total debt that is owed. It's important that debtors know their rights when negotiating with creditors. In the United States, these rights are established by the Fair Debt Collection Practices Act.

The only advantage of debt settlement for the creditor is that he will at least receive some money. If the debtor is allowed to declare bankruptcy, the creditor may receive very little or nothing. Declaring bankruptcy is a legal process in which the debtor's assets are turned over to a trustee who then liquidates the assets to pay off the various creditors.

In the United States, the most common type of personal bankruptcy is called Chapter 13, in which the debtor retains some assets -- like a home or car -- and is required to adhere to a court-ordered debt repayment plan in which a percentage of his regular income is used to pay off creditors. After the debt repayment is completed, the debtor receives an official discharge clearing him of any further obligations to his creditors.

Now let's look at consumer debt and its effect on the overall economy.

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