The deep recession that began in 2007, record levels of consumer debt, and a desire for increased financial security have sparked a growing interest among many American families in becoming debt-free. If you are one of these families and think that the best way to get out of debt is to focus on paying off your bills as quickly as possible, think again. Paying off debts is only part of the answer to becoming debt-free. And it’s not even the most important part.
Credit must be replaced by savings
In order to get out of debt and stay out of debt, the credit that has been used to finance purchases in the past must be replaced by a cash reserve (savings). A cash reserve allows you to pay cash for things instead of borrowing to pay for them.
Don’t confuse the cash reserve with retirement savings. The cash reserve is money you can get your hands on quickly. It is short-term savings. Retirement savings is long term and difficult to access. It is not a substitute for a cash reserve.
Creating a cash reserve is the most important thing you can do to become debt-free. However, motivated by a desire to escape the burden of crushing and seemingly interminable installment payments and the high cost of credit, you may be tempted to take any spare money you have and make extra payments on loan principal rather than save it. This strategy reduces the cost of credit by lowering the amount of money on which interest is charged. It also accelerates repayment of the debt.
Focusing solely on debt repayment may sabotage your efforts to get out of debt
Accelerated debt repayment is attractive because of the prospective savings on interest charges. The money saved on interest can be applied to the repayment of other loans, paying them off quicker. Once the debts are retired, the money saved on interest can be invested in savings.
Saving money on interest may have a great appeal to you. After all, who doesn’t want to save money? However, by focusing solely on accelerated debt repayment, you may actually sabotage your efforts to get out of debt.
If you put all of your resources into debt repayment and ignore the need for a cash reserve, you will continue to turn to credit to handle emergencies or unexpected needs, prolonging your indebtedness and interest payments. You will remain trapped in a cycle of debt.
Break the cycle of debt permanently with savings
To break the cycle of debt, resources have to be channeled into savings to build a cash reserve at the same time that debts are being paid down. Instead of devoting extra money to accelerated debt repayment, continue to make the regular payments on debt and put the extra money into savings. Do this until you have accumulated an amount equal to three to six month’s take-home pay. A cash reserve of this size should preclude the use of credit.
At this point some resources can be diverted to accelerated debt repayment. However, saving should not be abandoned. It is important to add to savings regularly. Only savings will keep you out of debt.
Building a cash reserve and paying down debt simultaneously guarantees that you will eventually get out of debt for good. You will not have to turn to credit to finance an emergency or unexpected need. You can tap your cash reserve instead. In essence, you become your own banker. The cash reserve is your bank. Start building it today and break the cycle of debt.
Copyright 2009 K.C. Knouse
K. C. Knouse is the author of True Prosperity: Your Guide to a Cash-Based Lifestyle, Double-Dome Publications, 224 pages