What to Do With Debt: Paying Off Debt With Profit First
If you’ve experienced debt in your personal life or your business, you know that it can feel suffocating. Your financial walls are closing in on you, and you’re ready to get rid of it once and for all.
We’ve talked before about good uses of debt vs. bad uses of debt, and there’s an important distinction. But aside from that, we think it’s important to let go of consumer debt and other debt sooner rather than later.
But how exactly? We can and will help you with this. But before we get into our recommendations for conquering debt, we need to lay some ground rules.
What does Profit First say?
First things first, you cannot pay off debt unless you are profitable. So how do you get profitable? By setting up Profit First, of course. Before you create your plan to pay off debt, you need to make sure all your Profit First pieces are in order. This way, your business will continue to run smoothly while you achieve your financial goals.
What pieces do you need? Take our Profit First Assessment and get a list of what accounts to set up!
Getting started with your debt
Step one to taking control of your finances is to control spending. By running and analyzing an expense report, you will fully acquaint yourself with every financial transaction in your business. You’ll gain a deeper understanding of where the money in your business is going and how you can control your spending.
The next step to paying off debt with Profit First is to understand the intention behind your accounts and allow yourself some grace. This is true whether your debt is in your business or personal finances.
The minimum payment of your credit cards, loan payments, or whatever type of debt you find yourself in comes from your operating expenses. Your bill is covered at its minimum each month. Any additional payments to the principal come from quarterly profit distribution.
That’s right. Each time you take a quarterly profit distribution, you’re still pulling 50% of your Profit account out for a distribution. But 45% of that distribution should go to your debt while you take 5% as your owner’s profit. We don’t recommend putting your entire distribution toward debt because you still deserve a reward for being the owner. Do something fun with it!
This is the “grace” part. You work hard. By allowing yourself some wiggle room to have fun once in a while, you’ll stave off burnout, so you’ll stay strong for the long haul.
Now that you have the Profit First debt-busting basics down let’s look at a couple more “must-dos” when managing your money.
Why would I save to a savings account if I’m trying to pay off debt?
Let’s get real for a second. Debt comes from spending too much before you have it. So make sure you don’t make a similar mistake by aggressively paying your debt down before you have other financial safeguards in place, i.e., an emergency savings account.
For many clients, the tendency is to put all of their profit toward debt as quickly as possible. We like where your head’s at, but what’s the point of paying off your debt if you are one big emergency away from creating more?
What happens when you’ve paid off all your debt (without emergency savings in place) and your HVAC breaks? You’re right back where you started, except this time, you’re more frustrated and in debt than you were previously.
Creating an emergency savings plan does prolong your journey to becoming debt-free, but it’s the only way to ensure you stay that way once you get there. Unfortunately, emergencies do happen—and usually when you least expect them.
What can you do in the meantime?
Your small plates are in place, you’re paying minimum payments from operating expenses, and you’re building your emergency savings account. Here are four debt management basics you can implement while you’re saving. (These aren’t Profit First principles, just good old-fashioned best practices.)
- Call your lenders. Ask if there is the option to refinance credit card debt to lower your payments or ask about the possibility of getting a better interest rate. There is no harm in asking.
- Transfer balances. In the short term, you will have transfer fees, but in the long term, you’ll save because you’ll lower your interest rate.
- Explore the possibility of your business getting a bank loan to pay off credit card balances or other debt.
- This is the big one: You need to have the discipline not to use your credit cards again. You are doing all this work. Don’t let yourself end up in the same position in the future.
Managing debt is a beast. But the struggle toward financial freedom is underway. You’ve set up Profit First and created emergency savings. Now all that’s left to do is stop blaming yourself for being in your current financial position.
No matter how much you might hate your debt, realize that it gave you experiences that have brought you to where you are today. Your debt afforded you opportunities, but now that you are making a profit, you don’t need it anymore. So leverage the income you have, say thank you to debt, and show it the door.