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5 steps to dumping debt
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July 2, 2001: 12:40 p.m. ET
Experts say stop spending, set a budget and borrow carefully
By Annelena Lobb
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NEW YORK (Money.com) - It's a rare person who can escape debt altogether. And truth is, not all debt is bad.
Mortgage debt and student loans are often a necessary part of living and building your net worth. But other debt – namely those escalating credit card balances – is just plain trouble.
The average American had more than $7,000 in credit card debt last year. With the average interest rate on credit card balances running around 17 percent, those balances rise far too quickly.
Tackling debt requires discipline, but it can be done. These five steps will put you on the road to a better financial life.
Stop the spending madness
The only debt you should have is the kind that helps you increase your net worth, said Dee Lee, a certified financial planner and author of Everywoman's Money: Financial Freedom.
Most of us can't afford to pay cash for our homes, and as long as you don't borrow so much that you can't keep up with the payments, a mortgage will help you increase your assets as well as put a roof over your head.
Often, it also makes sense to borrow to buy a car or pay your own tuition bills.
Borrowing to finance your children's education is a bit trickier – it depends on whether keeping up with payments might jeopardize your own retirement savings. Students have a wide variety of sources to help them foot the bills, but there's not much you can do if you haven't squirreled away enough for your golden years.
As for credit cards, they should be used only for convenience. Never use them to buy something you can't afford otherwise.
That means forgoing things like vacations and new clothing until you are able to make your monthly payments in full. "In the back of your mind you should always be thinking, 'I cannot purchase something unless I can afford to pay cash for it,'" said Lee.
Make a budget
Before you can start paying bills successfully, you need to figure out exactly how much money you have to put toward your debt.
Financial planners suggest keeping your total debt to less than 36 percent of your income. It's a worthy goal, but to reach it, you'll need to find out exactly where your money is going. Write down every single penny you spend for one month.
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 KEEPING IT REAL
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It's a good idea to keep your total debt to less than 36 percent of your income.
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Make sure you include every check you write, every credit card purchase, and every ATM withdrawal. At the end of the month, group the expenses into such categories as food, entertainment, and rent.
You'll now see which expenses are fixed – that is, you have to pay them each month – such as your rent, transportation and utilities, and which are variable.
The fastest way to save money is to cut spending on entertainment, food and clothing. If you are still unable to meet your bills, you'll have to take more drastic steps to reduce your fixed expenses or earn additional income.
Make a payment plan
If you carry a balance on your credit card, you'll end up paying far more for everything you buy, thanks to those whopping interest rates. Don't fall into the trap of paying only the minimum on your credit cards.
On average, it takes about 20 years to pay off a balance by just sending in the minimum payments. Instead, once you pay your fixed expenses each month, use any remaining money to pay off the balance with the highest interest rate first, while putting the minimum toward any other cards.
Once that balance is paid in full, do the same with the balance on the card that carries the second-highest rate. If you have more than one or two credit cards, cut them up as soon as you finish paying off the balance.
If you can't make payments on a car or student loan, try to negotiate with your lender. Many are willing to work out some kind of repayment plan – it's better for them to get some money back than nothing at all.
If you own a home, consider refinancing your mortgage. Refinancing often makes sense if you are paying a rate considerably higher than the current average rate (Find current rates on CNNfn.com and Money.com.)
By getting a lower interest rate, you may be able to lower your monthly payments and you'll surely pay less interest over the life of your loan.
Borrow carefully
If you've made a genuine effort to pay back your debts and are still under water, consider taking out a loan.
If you're a homeowner, refinancing your mortgage is often the best option, but you may also take a loan against the equity you've built in your home. Home equity loans generally carry rates slightly higher than current mortgage rates, but far less than the average credit card rate. And the interest, like that on your mortgage, is tax deductible.
Click here for more tips on how to control your debt from Money.com.
But home equity loans are no magic bullet. They are still a form of debt – and you may be putting your house at risk. Make sure that you get a loan with a low interest rate and that you will be able to meet the monthly payments. Shop around for the best terms.
Another option, but one experts recommend only as a last resort, is to borrow from your retirement funds. Most withdrawals from a 401(k) before age 59-1/2 will be hit with a 10 percent penalty, plus ordinary income taxes on the withdrawal.
Some companies allow you to take a loan from your account, which generally must be repaid within five years. The IRS requires plans to charge a "reasonable" interest rate, a provision most plans interpret as a rate one or two points above the prime lending rate from commercial banks. Some plans add processing or annual fees, and most limit the size of the loan to $50,000 or half the account value.
What's more, you'll lose a valuable opportunity for tax-free compounding of your retirement money.
Get help
If you're still stuck, consider getting outside help.
Certified financial planners are one option – they will help you create a budget and a strategy for getting out of debt. Credit counseling services are another option. Good credit counselors offer educational programs, help you make a budget, and may set up a debt consolidation program.
Consolidating your debt means assigning the counseling agency to work with your creditors.
Essentially, you pay them a lump sum that they disperse to your creditors. Your credit counselor will work out a repayment plan with your creditors and give you a fee schedule. None of your debt is forgiven, but you will extend the time you have to repay it, according to Nancy Judy of Myvesta.org, a non-profit debt consolidator.
Before signing on, ask plenty of questions. Make sure you understand if there are any fees and how long the program will last. Reputable non-profit counselors charge a small fee, around $15 a month, which should be clear from the start. Steer clear of companies that charge large up-front fees and do not offer any educational services. Look for agencies affiliated with the National Foundation of Credit Counseling.
Using a counseling service for debt consolidation might show up on your credit report for up to 10 years if one of your creditors chooses to report it, according to Craig Watts of Fair Issac and Co., a company that does credit scoring for lenders.
But Watts says participation in a debt consolidation program will not lower your FICO score, which is a number widely used by lenders to determine the likelihood you will default on a loan.
Still unsure if you need help? Myvesta's Nancy Judy offers three common signs that a problem has gotten out of control: if you're unable to meet your monthly payments, if you're taking cash advances from one credit card to pay off another, or if you are using your credit card for necessities that you used to pay for with cash. 
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