Getting Out of Debt

American consumers have accelerated into debt overdrive. Currently consumers are carrying about $1.3 trillion in non-mortgage debt. The average credit card holder has four cards and about $4,000 in high-interest debt. Sound familiar? Whether you're struggling to emerge from a mountain of plastic debt, or just longing to get better control of your credit cards, there are strategies you can quickly employ to dramatically lessen your debt and improve your financial future.

1. Call a halt to new charges.
The smartest money-management move you can make is also the simplest: to reduce old debt quickly, avoid incurring new debt. Once your credit card debt is paid off, resolve to pay off all new credit cards charges in full when the bill comes.

2. Know your limits.
Do you know how much you owe? Millions of Americans are so afraid of their debts that they avoid tallying up how much they actually owe. Yet knowing exactly where you stand financially is the essential first step to getting out of debt. Many experts believe that you should always try to keep your consumer debt payments to less than 10 percent of your before-tax income. For this calculation, debt payments do not include first mortgages or home equity loans, but they include all other borrowed money, such as car loans, credit-card debt, personal loans, student loans, and installment loans.

To find your monthly debt/income ratio, add up all your monthly debt payments and then divide the total by your monthly gross income. For example: $400 in monthly debt payments divided by $1500 in monthly income equals .26 debt/income ratio, or 26 percent.

3. Set a realistic goal.
Your main goal may be to get out of debt entirely, but depending on your debt level, that may be too overwhelming to accomplish right away. To keep up your incentive, try setting smaller, more immediate goals that you can celebrate as you reach them. Paying off one credit card is a good example. When you've reduced your debt to the goal you've set, you can use the extra money you'll have each month to reach other goals.

4. Prune your plastic
Though it's rarely a good idea to carry more than two credit cards, most people own a bundle. This increases the potential for fees and penalties, makes it difficult to keep track of balances, and of course adds even more impulse-buying firepower to your wallet. Start your pruning with department store credit cards, which tend to carry interest rates of at least 19.8 percent. You won't miss them; if a store is large enough to have its own credit card, it most likely will accept other major cards such as MasterCard or Visa.

Caution: Don't just stick your unwanted cards in a drawer and stop using them! The account remains open until you tell the company to cancel, and it will continue to appear on your credit reports. An open but unused account just invites fraudulent charges, so be sure to notify the company in writing that you are closing the account. Keep a copy and proof it was received, either by sending a check to pay off the balance, or mailing your letter certified mail, return receipt requested.

5. Prioritize your debt payments.
Make up a spending plan that will include payments to cover the minimum amounts on all your loans and credit cards. Develop a strategy for reducing your debts as quickly as possible. You can do this in one of two ways:

• pay off the debts with the smallest balances first. Putting a little extra money toward the smaller-balance bills gives you a psychological boost, as those debts are more quickly eliminated.

• pay off high-rate cards first. This method saves you the most in the long run. That's because those high-interest cards eat up most of your monthly payments in finance charges, instead of going toward paying off your bills. Once you've paid off the most expensive bills, more money is freed up to pay other bills--what's known as the the "debt snowball" effect.

Assume you have $1,000 that you can either choose to keep in a money market account earning 5 percent monthly, or use to pay off a credit card with a 17.8 percent interest rate. In one year, your savings will earn $51.16 in interest, compounded monthly. If you're in a 28% tax bracket, that account nets you a mere $36.84 after taxes. Meanwhile, you will have paid $163.88 interest on your credit card that year.

Consider your other choice: If you paid off the credit card, you would forego the $36.84 in net interest on the money market account, but you would avoid paying the $163.88 in interest charges. Total savings: $127.04

Tip: If you want the safety cushion of a savings account, you have the option of keeping a fully paid-up credit card for that purpose. An even better alternative: get a low-interest-rate card you keep locked away for use only in an emergency. Just remember: if your cards are charged to their limits, and you have no other financial safety net, don't tap your savings account until you have paid down at least one of your credit cards.

7. Consolidate (with Caution)
It's such an appealing idea: consolidate your credit cards and other personal loans into a single loan that lowers your monthly payments and makes it easier to pay your bills. As a bonus, you have a better sense of where your money is going every month, and how much you have left to pay off.

But before you consider the various methods of consolidating your loans, be aware that debt consolidation can be hazardous to your financial health: Unless you are committed to creating no new debt as you pay off the old ones, you could end up in even deeper debt than you were before.

You can consolidate your bills in several ways. The easiest is to simply switch to a cheaper credit card. Switching from a high-rate credit to a lower-rate card can easily save the average person at least $100 or more in interest a year, and even more over the life of the loan. If you qualify for a card offering a rock-bottom interest rate for the first six months, that rate--some as low as 3.9 percent--can be an incentive to pay off your debt before the introductory period is up. (Just be vigilant about knowing when the interest rate switches and how quickly you'll be able to pay off your debt, or you may find yourself paying a steep rate when the teaser rate expires.)

Other methods of debt consolidation, such as taking out a home equity loan, are more complicated and involve pledging your home as collateral for the loan. Whichever method you choose, it's essential to realize that debt consolidation, by itself, is not your goal--you want to consolidate, then concentrate on paying down that loan.