Three steps to help reduce debt

With continued concerns about the falling value of homes, rising health care costs, and uncertain outlook for the economy, now more than ever, Americans need to set a new course with regard to managing their household finances.

If you are ready to face up to your own financial realities and set a plan of action, the time to act is now. The following three-part strategy may help you control your cash flow, pay off debt, and encourage saving so you can better handle the expenses that may have gotten you into debt in the first place.

Step 1: Track Your Spending

As a first step, keep track of your typical monthly expenses for three months to find out where your money is going. Also try to estimate unexpected expenses for a year’s time — auto and home repairs, gifts, vacations, etc. — and divide that number by 12. Once you have a record of your spending, compare your monthly outlay to your monthly income. If you have a surplus, this is the amount you can apply each month to paying down debt and building savings. If you have a shortfall, you’ll need to examine your expenses more closely to see what you can potentially cut back or cut out.

Step 2: Build Your Savings

A key to establishing good saving habits is to make saving even easier than spending. One tip is to set up separate savings accounts with separate goals attached to them. If you open them with the same bank, you can easily transfer money back and forth. Suggested account purposes:

“Emergency Account” to pay for unexpected life events. Your goal this account should be to build up at least three to six months of living expenses. This way, if you lose your job or need a lump sum to pay for a significant expense, you may not have to tap in to your other savings or ring up more debt. If you can direct 5% of your pay each month to this account, you’ll build up a nice cushion in about three to four years.

“Family Account” to help fund your children’s school expenses (such as class trips and team uniforms) or family vacations. Let’s face it: if you have children, you are always paying for something. Even if you don’t have kids, putting away money for a specific short-term goal, like a vacation, is a worthy savings strategy.

“Investment Account” to be put toward general or long-term saving goals. Hopefully, you already have a retirement savings account (either through your workplace or on your own) and perhaps a college savings plan. But having another account to save for other longer-term goals — maybe a nest egg to start your own business — can be a smart move.

Step 3: Stop Abusing Your Credit Cards

If you’ve accumulated significant credit card debt, you’ve first got to stop the bad behavior. Paying off debt is easier once you stop using your credit cards. Pay off your highest interest credit card debt first, making sure you avoid the “minimum balance trap.” Paying more than the minimum can make a big difference.

Next, work on consolidating your debt by transferring outstanding balances to lower-rate cards. If you don’t want to transfer your balances, you may be able to get your current credit card company to match the interest rate of a competitor. Additionally, it’s advisable to cancel all cards except for the one that offers the lowest interest rate.

Finally, set up a realistic payment timetable and stick with it. If you need to readjust your timetable, do so. If you have trouble, talk to a professional. The counselors at the nonprofit National Foundation for Credit Counseling can develop a more structured plan for you, if needed. To find the nearest location, call (800) 388-2227 or visit www.nfcc.org.

© 2012 S&P Capital IQ Financial Communications. All rights reserved.

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