One of the main pitfalls of Personal Finance is the amount of debt a person end up with. Lifestyle creeps, unexpected expenses, low or loss of income all can contribute to increasing debt and crippling finances.

There is of course good debt vs. bad debt, but most often than not, people run into the bad debt issue. The bad debt is usually in the form of Credit Cards, Personal Loans and Car Loans.

Home Mortgage and Student Loans can be considered as Good Debt, depending on how the money is used. If it is used to generate income (or projected income) that will be more than the cost of the debt itself, then it can be considered Good Debt.

Bad Debt, however has only downside effect. The interest rate charged are often exorbitant to the tune of 20% or more per year. There is hardly any investment that can return that much income consistently to cover the cost of this debt.

So the Point A of a person can be having quite a bit of Bad Debt.

The Point B is to become Bad-Debt free.

Let’s see how a simple four step financial organization can help in this transformation.

Financial Reboot

The first step of the process is to take an objective view of the finances. Looking at this as a complete picture, tells us what are the possibilities and roadblocks in achieving the debt free transformation.

Once we have the above 8 numbers, we can do a quick analysis of the financial situation. This is really Point A stage.

• What is the slack in the budget?
  • S = Income – Expenses – Debt Payments – Rent
• How many months of emergency fund can be built from the savings?
  • E = Total Savings / (Expenses + Debt Payment + Rent)
• What is the debt-to-income ratio?
  • DTI = (Debt Payment + Rent) / Income

and several other ratios and metrics can be calculated.

In this stage, the idea is not to overwhelm the client with numbers and ratios. But we try to bring out the positives of the Point A through this analysis.

Often times, after seeing this the client feels more hopeful towards their future.

Financial Plan

In this step, we look at the Financial Reboot analysis and create goals.

This typically requires arranging the debts in a certain order – either by balance or interest rate. There are debt payoff strategies based on either paying off the lowest balance first or the highest interest first.

But in reality, it is not so simple. Clients have different emotional value for certain debts. For example, a car or truck bought with debt will have more tangible and meaningful value than credit card debt.

Asking the client to sell off the car may not always be the right approach.

One safe approach could be attacking debt without any more tangible value, for example, credit card debt due to previous purchases. The purchased item may or may not be there with the client, and often it is not worth selling it.

The other complexity is with 0% loans for a fixed tenure. Usually this debt can be costliest once the interest free deadline is over.

So paying off debts in the order of interest rates or balance is often not the right solution.

We have to take a personalized and pragmatic approach to this plan.

Financial Flow

Creating a plan is one thing. Executing it flawlessly is where rubber meets the road.

In this case, the previous step will identify which debts will be paid off and how.

There are 3 ways in which a debt can be paid off.

• One can sell the underlying asset, for example, a car or a furniture
• One can use savings to pay off
• One can use monthly slack (S) to slowly chip away the debt over time

In all the 3 cases, the reality is not so simple.

• The underlying asset may have a usefulness, for example, car for going to work.
• The amount of savings to use. There may be other financial goals or need for an emergency fund, all of which requires the cash.
• Keeping the slack intact in the budget month after month by controlling the expense or increasing the income.

There are several nuances to debt payoff execution that are not apparent just by numbers.

Financial Growth

By following the above 3 steps, a person can get out of debt over a period of time.

However like any bad habit, getting into debt is often an addiction. Once getting free from it does not mean the next month, the next purchase will not put that person back into the debt hole.

In this case, staying out of debt and developing a debt free mindset is important.

Research says that the best way to get rid of bad habits is replacing them by good habits. Few strategies could help in this:

• Put the previous debt payments into regular investments.
• Realize that debt means one is punishing their future self.
• Realize that lenders are not your friend.
• Develop other meaningful goals to stay away from consumerism.

Thus there is a huge mindset work that needs to be done to stay out of debt.

Conclusion

All of the above have human behavior and needs associated with them.

Hence just knowing the process does not guarantee success for an individual.

In most cases, the client needs the help of a Financial Coach to help her prioritize, plan and execute the Point A to Point B transformation.

The 4 step process I use in my Financial Coaching to help my clients make such Financial Transformations in their lives.

Email info@startyourfinancesright.com if you want to know more.