Six Simple Steps to Avoid Credit Problems in a Bad Economy

By Leo Babauta

The New York Times ran a story today that says the next consumer crisis is credit cards — a sobering fact in a nation that has racked up massive amounts of credit card debt.

Unfortunately, when times get hard, many people turn to credit cards to help them make ends meet … and only dig themselves into a deeper hole.

I’ve been through this myself, buying things on credit when I had no other way to pay for them. I’m not talking about plasma TVs, but about necessities like medical bills. As a result, I dug myself deep into debt, and one of the biggest decisions of my life was to get rid of credit cards and begin eliminating my debt.

At the beginning of this year, I finally got completely out of debt, and I celebrated. But it wasn’t easy. It took some hard decisions, some sacrifices, and a commitment to change my spending habits.

I highly recommend that people get out of debt and stay out of debt, especially as the economy hits difficult times. It’s not a good position to be in if you lose your job while burdened with lots of debt. Better: become debt-free, with a good emergency fund and a small budget. That’s recession-proof personal finances.

Here’s how to get there in six steps:

1. Curtail spending. The first step is to stop the bleeding. If you’re trying to get out of a hole, you’ve got to stop digging first. So make the decision right now to not use your credit card except in emergencies. Cut back on your spending in any way you can, at least for now as you try to get out of debt. Consider tracking your spending for a week or two at least, writing down every purchase, so that you can see where your money is going. Some suggestions for cutting back: eating out, going out, magazines, expensive coffees or other drinks and snacks, new gadgets, non-essential clothing purchases, non-essential furniture or home purchases, to name a few. Now, I’m not suggesting that you never eat out or go out to have fun — but I am suggesting that you cut back on these types of spending. Find other ways to have fun that don’t cost as much.

2. Save an emergency fund. With the money you save from Step 1, begin saving an emergency fund as quickly as possible. Let’s say you identify $200 per paycheck that you can save from cutting back on specific spending items (as an example — your amount will vary). Now put that $200 into a savings fund each paycheck, and within 5 paychecks you’ll have a $1,000 emergency fund saved up. This is extremely important, as there will always be unexpected emergencies that come up (you have to go to the hospital, you car breaks down, you home floods, etc.) and many people will use credit cards to pay for these expenses when they don’t have an emergency fund. If you have an emergency fund, you can avoid going deeper into the hole when these expenses inevitably come up.

3. Make debt elimination a priority. Once you have a small emergency fund saved up ($1,000 is best to start with, but you can get by with as little as a $500 fund), begin channeling your extra money toward debt repayment. Make this a top priority, or you won’t get to it. That means make it your first payment each payday: set up an automatic payment at your bank where you automatically pay an extra amount to your highest-interest debt. Pay the minimum on your other debts for now, and once you pay off the highest-interest debt, put all your extra money to your next highest-interest debt … and so on, until all debts are paid off. An alternative is to pay your smallest debt first, then focus on the next biggest debt, and so on.

4. Scale back your lifestyle. While Step 1 asked you to find ways to cut back on spending immediately, there are longer-term changes you can make that will have a big impact on your spending. For example, you could trade in your large car or SUV for a smaller, less-expensive car that gets better gas mileage. You can eventually move to a smaller home and get rid of a lot of the clutter in your house that requires a lot of space. You can work at cooking at home more instead of eating out, brown-bagging it to work instead of having expensive lunches, making your clothes last longer instead of buying new clothes all the time, and deciding you don’t really need the latest computer, TV, video game system, or smart phone — the ones you have work well enough already. These changes may take time, but a commitment to scaling back can pay huge dividends over time.

5. Make sacrifices and buy on cash. This is an extremely important habit that may become the keystone to this entire plan. While many people buy on impulse and put purchases on credit cards so they can have it now, that’s rarely necessary. Rarely do you really need to make a purchase right away. A much better habit is to save up until you have enough money to buy the item on cash. Get into the habit of waiting. Sure, maybe you need new shoes, but can you wait until you have the $50 to buy them? Yes, you can. Sure, maybe you need a new computer, but can you save up the $1,000 you need for it? It’s possible. It’s even possible to make your current car last longer and save up enough to buy your next car on cash — I did this with my last car purchase (actually it was a slightly used mini-van), trading in my SUV and paying the balance on cash. The key is to wait, save up, and buy on cash.

6. Make a commitment to stay away from credit. Getting into some debt may be unavoidable — student loans, for example, or housing loans are usually seen as good debt, especially at low interest rates. Even auto loans aren’t necessarily bad debt, although as I said above, it’s possible to save up enough money to buy a decent used car on cash so you can avoid getting into that debt. But credit card debt is rarely ever desirable, for the average person. I’m not saying you should never use credit cards — obviously they are convenient for online purchases or traveling, although for these purposes you could use a debit card that’s backed by a major credit card company in most cases (I have). But my advice is to just have one credit card (cancel all the rest) and to keep the balance at $0. Only use it when you actually have the money in the bank, and then pay it off immediately. Don’t use your credit card when you don’t have the money — that will just lead to trouble. Make a commitment to doing this, and you’ll avoid credit problems and be in good shape, whether a recession hits or not.