You’ve written a budget, have a good idea where you’re spending and where you might economize, and now you’ve thought about some ways to work frugal habits into your lifestyle. One of the goals for these activities is to pay off your debt, so that you can spend or save your money the way you want to and stop worrying about how you’ll cover the next credit-card bill or mortgage payment.

Freedom from debt is freedom from stress! And since we know that stress can make you sick—to say nothing of making you unhappy—getting quit of it is worth some effort.

For most of us, paying down debt is the hardest part of our financial strategy. Though it is a challenge, it’s not impossible. It just takes patience and determination. Anyone who’s willing to stay focused for a while can do it.

What’s wrong with a little debt, you may ask? After all, it’s the American way. Didn’t the President of the United States, after 9/11, tell us that going out and spending is the patriotic thing to do?

Well, I’m not going to argue about whether sinking the citizenry into a slough of debt is good for the country. But I’m very sure that it’s not good for you or for me. Debt robs you of your buying power.

Debt cuts your buying power in the obvious way, by taking a chunk of your income every month, leaving you less cash for the things you need and want. It robs you in another way, too: through interest. Many credit cards have interest rates that can only be called usurious. Usury is a practice of gouging borrowers that once was illegal. For many generations it was considered immoral. Now it’s simply business as usual.

Let’s suppose you run a tab on a card with a 21 percent rate. Effectively, every dollar you charge is really worth 79 cents: 100 cents minus 21 cents. It’s actually worth less than that, because the piratical interest rates compound in mysterious ways as your debt runs from month to month, so that by the time you’ve finished paying for, say, an iPod, you’ve paid twice as much as the retail price.

In fact, a whole blog has grown up around this realization: I’ve Paid for This Twice Already, whose proprietor has chipped a $36,450 debt down to $27,700 since June 2007. That’s almost ten grand in seven months!

It is possible to do it. Here are the keys to unlock the gates of the credit-card debtor’s prison:

1. Stop charging NOW!

2. Pay the minimum on each debt you have on the books.

3. Try to consolidate revolving debt on the card with the lowest interest rate you can get.

4. Budget a monthly amount that you can pay toward the principal on your debt (this is the base amount you owe, exclusive of interest).

5. Also budget a monthly amount to put into a safe investment, building an emergency fund.

6. Practice frugal habits, so that you can live on the amount you are paid without having to run up more debt.

7. Develop more than one income stream. If you don’t have a job, get one. If you have a job, get second job. If you have a hobby or skill that can make money, monetize it. Do freelance work, take in a roommate, sell your junk in yard sales or Craig’s List, mow lawns—do what it takes to earn some extra cash.

8. Pay your budgeted monthly principal paydown on one, and only one, of your debts. Keep paying this until you have paid off the debt. Then take your budgeted monthly payment and apply it to the next of your debts. Repeat this process until you’ve eliminated all your debt. (This technique is called snowballing).

9. Take every windfall, every bit of loose change, and every few bucks left in the bank at the end of each month and apply it to your debt principal. (This is called snowflaking, a term coined by Paid Twice). “Windfalls” include your earnings from side jobs, tax refunds, profits from yard sales, bonuses, gifts of cash, rebates from purchases, loose change, etc.

So, let’s say you have three credit cards with balances of $5,000 at an introductory rate of 3 percent increasing to 18 percent in 10 months, $895 at 15 percent, and $2,500 at 21 percent. You also have a $24,000 student loan with a 6 percent interest rate, a car loan of $15,000 at 8.5 percent, and a mortgage on your condo of $95,000 at 6.125 percent.

Where to start?

The cards

Begin with revolving debt: credit cards and store cards. Because these are extremely expensive, they represent the most destructive debt you have. Thanks to these cards, you really are likely to pay twice as much as retail for everything you buy. The other debts are relatively affordable and in some cases (such as the student loan and the mortgage) probably return more value than they cost, at least over the short run.

Some people agree with Dave Ramsey that you should start with the smallest debt, so that you get a morale boost at the earliest possible moment. The theory goes that one small success will encourage you to go after the next success. Others suggest that you start with the highest-interest debt, since that’s costing you the most, and then work toward the lower-interest balances.

You know your own psychology. If you need plenty of carrots to keep you going, then you should start paying down the smallest balance. In our example, this would be the $895 owing on a credit card. If you pay down the principal at $100 a month and snowflake as much as you can, you’ll probably get rid of it in seven or eight months. Then you’ll start whittling away the $2,500 debt, which with any luck you’ll eliminate in 18 or 20 months. From there you would move on to the $5,000. If you add the minimum amounts you were paying on the now retired debts to your $100 monthly payment and continue snowflaking, you’ll be rid of the five grand under four years. Obviously, the more you can put into your regular monthly principal pay-down, the faster you will get out from under the credit-card debt.

Personally, I would start with the highest-interest debt, the 21 percent credit-card of $2,500. Each payment toward principal pulls down the amount that the usurious lender can use to soak me for 21 percent interest, and so as time passes my monthly payment reduces the debt a little faster. I have ten months before the $5,000 debt jumps from 3 percent to 18 percent, and so that balance grows much more slowly than either the $895 balance (15 percent) or the incredibly expensive $2,500 balance.

Even after the introductory rate ends, the card with $5,000 on it, at 18 percent, is still better than the 21 percent soaking I’m getting on the $2,500 debt. It would make sense to roll the $2,500 debt onto the card with the introductory rate, giving me a total of $7,500 at 3 percent for 10 months and then 18 percent until the end of eternity.

That would leave the $895 at 15 percent as the most expensive balance, at least over the next ten months. At $100 a month plus snowflakes, I can pay off the 15 percent loan in eight months, during which the introductory rate on the other card still applies. Then I may have a couple of months at the lower rate to start chipping down the principal on the $7,500 card. At about $120 a month plus minimum payment, it will take five or six years to pay this off. If I can raise my principal payment to $200 a month, I can get rid of this onerous debt in three years; and if I can pay $250 a month, the debt will be gone in about two and a half years.

As a practical matter, with a second income stream you probably can pay more than $250 a month, allowing you to get close out the credit-card debt in much less time.

As you pay down the credit card debt, your credit rating improves, because your debt-to-credit ratio looks better and better. A lot of available credit, believe it or not, looks good on a credit report. So, don’t cancel the cards as you pay them off; just lock them up. The freezer is a fine place to keep them, since they’ve put you in a financial deep freeze.

Once you’re free of the credit cards, you still have the car loan, the student loan, and the mortgage. Which to attack first?

The Rest of the Debt

The car loan should be your next order of business. A car loan is a terrible deal, almost as stinky as a car lease. Because you’re adding interest atop the debt, the actual amount you pay for the vehicle increases vastly over the sale price. But because the car’s value does not increase but in fact decreases, you are getting…well, yes. Screwed is what you’re getting.

Chances are you have a five-year loan. Every payment you make toward the principal cuts the amount of time it will take to pay off the loan. So, just keep right on snowballing and snowflaking. Before long, you will own your chariot free and clear. A real liability is now an asset, albeit one whose value is slowly dropping. Hang on to it. Drive it until it falls apart like the minister’s one-horse shay. The longer you keep it, the more likely you will be able to save enough to pay cash for the next heap.

Now what? Student loan or mortgage?

Well, the mortgage is supposedly giving you a little break on your taxes. Not only that, but over time the value of the asset you’ve borrowed against will increase (have faith!), plus some of each payment accrues as equity in that asset. The student loan, meanwhile, just sits there and absorbs cash.

Kill it! By now you should have had a raise or two. Instead of fancifying your lifestyle, you’ve used the raises to help pay down loan principal, and so by now your budget for monthly principal payment has increased by the amounts of any raises in pay and by the minimum payments you were making on the now-defunct loans. This should give you a hefty budget for knocking out the student loan. (For another view on student loans, check out what Plonkee has to say.)

Finally, with the most evil income suckers off your back, you’re almost free. You now have a nice chunk of money coming in your paycheck that no longer flows straight into someone else’s pocket. What will you do with it?

1. • Buy yourself a present?
   

2. • Go on a vacation?
   

3. • Put the extra money into savings?
   

4. • Use the money to pay down the mortgage?
   

How about all of the above? Celebrate by getting yourself something you’ve wanted for a long time. Take a nice vacation (that you can afford—and don’t put it on the cards!). After that’s out of your system, split the amount you had budgeted for debt payment and put part of it into savings and part into the mortgage. Or, depending on your point of view, put it all into savings.

The advisability of paying off a mortgage is highly debatable. Obviously, if you’re upside down with your mortgage—if the house’s value has dropped below what you owe on it—you should put no more cash into the place than you absolutely have to. Think of the mortgage payments as comparable to rent, pay what you must, and sit tight until the real estate market turns around. Sooner or later it will.

If your income is relatively high and your mortgage payments are also substantial, it’s possible that the tax advantage is enough to make it worth maintaining the debt.

But . . . if you are no heavy hitter in the earnings department—or if you’re paying alternative minimum tax—the alleged tax advantage of a mortgage is highly theoretical. For example, when I paid off my mortgage, I was earning less than $40,000. If getting rid of the mortgage payments—which consumed half my take-home pay—made any difference in my income taxes, I sure couldn’t see it.

So…how did I pay off an $80,000 debt, about the equivalent of $115,000 in today’s dollars? By applying every spare dollar that I had. “Every spare dollar” included

1. • two years’ after-tax worth of a secondary income stream, about $38,000 stashed in a mutual fund;
   

2. • two years’ income from an old investment in a shopping center, about $4,800;
   

3. • two years of tax refunds, about $2,000;
   

4. • two years of freelance income, about $5,000;
   

5. • enough money taken from a mutual fund to cover what remained, about $30,000.
   

This required me to raid long-term savings, an act that elicited a shriek of dismay from one financial adviser and a raised eyebrow from the other. However, the result was that I had enough income from a single salary to live on—impossible when half that salary was going to mortgage payments. I paid $100,000 for the house and sold it a few years later, just before the bubble, for $211,000, an increase of about 9 percent a year. I wouldn’t have done any better in the stock market, and I ended up with the roof over my head paid for.

And freedom. I ended up with freedom from debt. That’s priceless.

This is one of Funny’s Ten Money Principles.

debt, personal finance