In today’s personal finance marketplace, there are hundreds of people trying to get you to buy their book or take their course because they have the secret recipe to help you get out of debt. Some of these programs are very helpful, others not so much. After cutting through all the noise, there are really only two options to consider when trying to pay off debt.
Debt Snowball vs. Debt Avalanche
The debt snowball method says to list all of your debts from smallest to largest and pay off the smallest debt first. Then snowball that payment into the next smallest debt and so on. Even though the smallest debt might have a higher interest rate, proponents would argue that the small victories help the person in debt to continue down the path towards debt freedom.
The debt avalanche method says to list your debts from highest interest to lowest interest and pay off the highest interest debts first. Once you pay off one debt, take the amount you were applying to that debt and apply it to the next highest interest rate debt. Continue this until you are out of debt.
I think both methods are a good choice and are highly dependent on the personality of the debtor. I favor the debt avalanche method as you will become debt free faster and will have paid less in interest. But this post isn’t about the two methods available. I want to highlight the area most people skip right over to get to the debt payoff methods.
Tracking Your Spending
The most overlooked portion of a debt payoff plan is knowing exactly how much you spend each month. I know that might seem obvious, but many people hate the idea of meticulously tracking their spending. Without knowing how much you spend each month, it is impossible to know if you need additional income, need to cut spending, or a combination of both. It really isn’t that important to focus on what you are spending your money on. It is much more important to understand your monthly cash flow in order to pay off your debts as quickly as possible.
Cash Flow = Income – Expenses
Example: if you have $15,000 in credit card debt and want to pay it off in two years, you will need a positive monthly cash flow of $625/month. It’s impossible to know if that goal is attainable if you don’t know how much you are spending! Everyone can look and their pay stubs and figure out how much is coming in, but very few people know what they spend each month.
The Three Month Challenge
I have a confession to make. I haven’t done a good job of tracking my monthly spending lately either. For the next three months, I’m going to highlight how every penny is spent. Will you join me in tracking your spending?
Steps to Track Your Spending Using Excel
- Open a new excel file and name it “Monthly Expenses.”
- On row 1, list every expense category that you spend money on. This would include housing, food, utilities, debt, interest, entertainment, clothing, gas, car repairs, car payments, the dog, etc. Whatever you spend money on, make a category for it. You can be as detailed as you would like.
- Use an envelope or an old shoebox to store your cash receipts. Anytime you buy something with cash, save the receipt and throw it in the shoebox at the end of the day.
- After the month is over, take your cash receipts and your bank statement (and credit card statement if you use one) and list each expense under the correct column of categories created in step 2.
- After you’ve entered all the receipts, use the AutoSum function to total your categories for the month.
- Repeat for the next two months.
After three months, you should get a pretty good feel for where your money is going. I personally don’t think one or two months gives a long enough horizon for unexpected expenses to show up. I also think it is beneficial to do this process manually. I know there are good automated products out there, but the manual process keeps me more engaged and in tune with my spending. Yes, it is somewhat of a hassle, but I’ve found this to be a better exercise than automating my finances.
Once you get a better handle on where your money is going, you can then decide if you need to trim down the budget, increase the income, or both! It is impossible to set good financial goals without knowing where you are spending your money.
Have you done a good job of tracking your monthly spending? Do you like to use a manual or automated budgeting system?
Oliver, you’re right: this is a crucial step if you want to get out of debt. Even though we’ve been working at cutting spending over the last couple of years, I wasn’t tracking spending. On Jan 1, we decided to track what we’d spent on eating out, gas, and food for 2012. Turns out we were wasting hundreds of dollars a month on “little things” here and there! Now that we’ve chosen to track spending, I’ve cut our grocery bill by nearly $500 a month, our gas expenses by $100 a month, and our eating out bill by over 75%. I can finally see why we’ve had money problems all these years! Tracking your spending really does work, and really is necessary to getting out of debt. Great post!