Dealing with debt is the first step in the construction of the bridge to financial freedom.

This bridge has three main components, the foundation, the substructure and the superstructure. Dealing with debt is integral to the financial freedom foundation and it is essential to the overall financial freedom strategy. Once you’ve dealt with debt, it will be much easier to achieve financial freedom.

The overall financial freedom strategy has three main phases. The first phase is dealing with bad debt. The second phase is growing your money. The third state is using that money to invest in cash flow producing assets.

Understanding the Impact of Debt

I’ve been wanting to come up with an illustration on how debt keeps people from gaining traction. I sketched something in hopes of making this easy to understand.

The top sketch shows a stick figure trying to fill up a reservoir with water. However, he is using a bucket that is continuously leaking. No matter how hard he works, filling the reservoir will be near impossible. As I am sure you’ve figured out, the leaking bucket represents debt and the empty reservoir represents security, wealth, and ultimately freedom.

The middle sketch shows a stick figure also trying to fill up the same reservoir. This stick figure is working hard, but somehow filling up the reservoir is consuming his entire life. Things are made much more difficult by the stick figure on the right. This represents the tax man, whom is happy to collect as much as he can from the hard working stick figure.

The third sketch shows water flowing from a water spigot. One reservoir is full and it is overflowing into a second reservoir. If you notice, the stick figure is giving the tax man a relatively small container. The reality is this stick figure owns investments such as real estate that have huge tax benefits.

But what’s more important is this stick figure is not even working. This guy figured out how to invest his money into cash flow producing assets!! And cash flow is the key to financial freedom.

The moral of the story is that to gain any traction with your personal finances it is first important to deal with the leaky buckets. This means getting rid of bad debt.

Dealing with Debt – Good Debt Vs Bad Debt

There are two kinds of debt, good debt and bad debt.  Any debt that is not contributing to wealth creation is bad debt.  For example, bad debt includes debt such as credit card debt, car loans, and arguably student loans, etc.  I say arguably, because depending on the loan and the result of that education many would agree student loan is good debt.

For the most part, dealing with bad debt boils down to setting goals, establishing an aggressive budget and sticking to it. 

Getting rid of credit cards and using cash instead is a great way to get started. Certainly, getting rid of things and services that aren’t necessary will go a long ways in saving money and getting rid of debt. Common examples of how many people tackle debt successfully include getting rid of cable TV, packing lunches to work, downsizing, etc. The point is establishing and getting used to a lifestyle of frugality.

Good debt on the other hand can be used as leverage to acquire income assets.  For example, taking out a mortgage to purchase an income real estate property can be good debt. Good debt is debt that will contribute to wealth creation.

Understanding Your Debt Situation

The first step in addressing debt must be determining how much debt you have. Start by creating a simple spreadsheet that shows the balance owed to each creditor, the interest rates, and minimum monthly payments.

You can find all sorts of debt reduction templates online. The one below looks simple enough. You can down load this at https://www.vertex42.com/Files/download2/themed.php?file=credit-repair-calculator.xlsx

Prioritizing Debt

Next, use this information to prioritize which debt to address first. Certainly, the debt with the highest interest rate should be given a priority, but perhaps you’ll be more motivated if you tackle the smallest outstanding balance first. That’s often referred to the snowball strategy.

Tracking and Goal Setting

This part requires a little more work, but this is where the rubber meets the road. In addition, this is the exciting part, where you get to visualize your progress. The intent is determine how much you can contribute each moth toward paying debt. The example below shows a monthly payment of $500. Once this amount is entered, you can play with the “Reduce To” amount to see how the graph at the bottom changes.

See 10 Expenses You Must Cut to Get rid of debt & Save Money Fast. This article shows how an average Joe focuses can save over $18,000 a year by focusing on 10 expenses. By investing this money this average Joe can grow his savings to well over $200,000 in 10 years.

Budgeting Simplified

The more important question here is how exactly should you determine how much you can pay each month. You can certainly come up with any amount that may seem reasonable. However, it is best to derive this amount after doing a budget. This may sound complicated to some, but it doesn’t have to be.

And I’d like to stress that it is better for you to spend just a little time on budgeting, even if your budget is only mostly right, than not doing so because you are overwhelmed at the thought of it. Thus, let’s keep things simple.

In simple terms, a budget summarizes income and expenses over a period of time. So, the first step is to write down the monthly income. And the next step is to list monthly expenses. See example below from familybalancesheet.org.

Perhaps one of the biggest things people struggle with when developing a budget is that they don’t know where they’ve spent their money. Obviously, tracking expenses would be very helpful, but if nothing else, let’s start by identifying the biggest expenses.

I am a big fan of the 80/20 rule. In short, this rule of thumb states that 80% of the results are attributable to 20% of the causes. With this in mind, we should focus our attention on the largest amounts (or about 80% of expenses). Everything else is much less important, but there is nothing wrong with adding more detail.

Once you have identified the largest categories, then see if there is a way to reduce those expenses. And then establish a budget for each category. Like I said, this doesn’t have to be a complicated process. You can certainly add more lines and more detail as you see fit.

Last, add up all the income and all the expenses to see if you are in the positive on the negative. Then revisit the expenses to see if there is anything that can be further reduced. Any amount left over can be used to pay off debt faster and/or for savings.

Don’t Give Up and Celebrate Small Victories

Tackling bad debt can be hard and frustrating. However, the long term benefits from dealing with bad debt are worth the battle. Give yourself permission to celebrate small victories. Something as simple as calling a friend to share how you’ve reached a debt milestone can be a great motivator.

Moving Forward

Once you’ve have a plan for tackling bad debt, it is also important to start saving for potential emergencies. And soon after it will be time to start saving for future investments.

As always, please drop me a note and let me know what other areas of business and finance you’d like to explore. Then, I’ll write more about your suggested topics as we pursue knowledge, financial success, and financial independence together. In addition, you can also follow me on Twitter at @Cash_Keen