What to do once you've finally paid off your debt

Adjusting to a debt-free life might be more difficult than you think

(Image credit: (Thinkstock))

When Bianca Osbourne* went away to college, she had a lot of new experiences to acclimate to: living on her own, exploring a new city — and opening up her first credit card.

As soon as she turned 18, she was inundated with card offers and started spending like crazy. Her parents had always supported her financially, and she was in the dark about managing money. It wasn't until she graduated from university that her dire financial situation (the debt reached $15,000 at its peak) hit her. "I remember waking up one morning, realizing just how much I owed, and asking myself, 'How did I get here?'" says Osbourne.

Overwhelmed and uncertain how to begin tackling the debt, she pushed it out of her mind, moved back in with her parents, and attended culinary school (funded by them). Once she finished her degree, at age 25, she finally committed to getting debt-free. She signed up for a credit-counseling program aimed at helping people in debt organize their money and pay their bills, and funneled between $140 to $250 a month into payments.

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"In the beginning, paying off the debt felt exhilarating because I was confronting the situation and acting on it," she recalls. "Then it got frustrating — I had started my own business as a chef and nutrition consultant and it started to really excel, but being in debt was limiting because I couldn't apply for loans or a credit card."

Two and a half years later, she could finally see the light at the end of the tunnel.

Great news, right? After all, this was what she'd been waiting for and working toward. But instead of being excited, Osbourne was nervous. "I was afraid that I would end up in debt all over again," she says.

She also felt tremendous pressure to succeed in her professional life once she was debt-free. "Now I'd have nothing but myself to blame for not being able to accomplish something," she explains. "Before, if I couldn't add an aspect to my business or go on vacation, I could pin it on the fact that I was broke. Now I'd have to step it up. My grace period was reaching a close, and I thought that people were going to expect leaps and bounds from me."

It's a surprisingly common position to be in: You finally achieve the impossible (or at least what seemed impossible for a long time) and become debt-free, but instead of feeling financially empowered, you have a deer-in-the-headlights episode. You're so accustomed to being in debt that you don't quite know what to do without it.

Why we can miss our debt (at least a little)

However counterintuitive it may seem, sometimes there's an emotional payoff to being in debt. "You might get more compassion from people than if you were well off, and it can give you an easy out if friends or family members frequently request financial assistance," says Brad Klontz, Ph.D., co-author of Mind Over Money and managing partner at Occidental Asset Management.

In Osbourne's case, carrying debt allowed her to justify that she was still receiving support from her parents, and gave her an excuse not to take certain business risks (or put herself on the line for ego-damaging failure).

Emerging from a cloud of debt can also throw your social life into disarray. "You're launching into an entirely new world," says Klontz. "People tend to lose friends whenever they jump up or down financially." Klontz, who came from a blue-collar background, carried a $100,000 student loan debt after graduate school. Worried that his fancy degree might alienate him from his circle, he went out of his way to emphasize that he was broke. "I found myself bragging about how much debt I had, because I still wanted to belong to the group," he remembers.

Plus, it's overwhelming to go from having a laserlike focus on a single goal — getting debt-free — to actually having to make choices about what to do with your money. Andrea Trevino,* who is working her way out of $65,000 in student loans, feels paralyzed by all of the avenues that will soon be at her disposal.

"Having and managing debt takes a lot of mental and financial resources, both of which will soon be available for other goals. There will be so many things I can do with the money, it's hard to know what the smart decisions are," she explains. "I'm unprepared to be in a good place financially, and I truly do not know what steps I'm supposed to take once I'm there. What do I do with what's left after bills? Savings accounts aren't all the same, you say? Get a 401 what?"

So, you're debt free. Now what?

At this juncture, a budget can be more important than ever. "Having a plan for where to allocate your discretionary cash flow will help keep you from falling back into debt," says David Blaylock, a Certified Financial Planner™ with LearnVest Planning Services, who, as a rule of thumb, recommends trying to allocate roughly 20 percent of your take-home pay toward your savings goals.

O.K. But what, exactly, should you do with that 20 percent? You can actually consider tackling a couple things — like building up your emergency savings and putting money aside for retirement — at the same time. We'll discuss how below.

Calculate what six months of your net income would amount to, and that's the sum you should consider shoring up in an emergency savings fund. That way, should anything happen (losing your job, getting in an accident, a sudden move), you'll ideally have enough to live on without having to take out loans. "The purpose here is accessibility and liquidity, not growth," says Blaylock. And try not to dip into that money, unless it truly is an emergency.

At the same time you may want to start saving for retirement, because, with this goal, time is your friend. "Start with your company's 401(k) plan," says Blaylock. Many organizations will match employees' contributions, which is like getting free money, plus you can arrange to have automated deductions from your paycheck pushed into a 401(k), simplifying the savings process.

If your workplace doesn't offer a 401(k) (small businesses may not), or you're self-employed or a stay-at-home parent, then consider opening up an IRA through a discount brokerage firm, like Charles Schwab, Fidelity, Vanguard, or TD Ameritrade. Discuss with a representative there which type of IRA might be best suited for you: Roth or traditional.

"At LearnVest, we believe that investing should be simple. For retirement, typically we recommend using an all-in-one fund solution like a low-cost target date fund that is in line with your expected retirement date," says Blaylock. Then ask the firm to set up a monthly automatic draft payment, which will withdraw a predetermined amount from your checking account each month so you don't forget to save. (If you need help with this, or determining how much you need to save for retirement altogether, a planner like Blaylock can also help you.)

You should also know that the government limits how much money you can put into tax-free retirement savings annually: $17,500 for a 401(k) and $5,500 for an IRA in 2014. "Once you're maxing out your annual contributions, it's time to focus on other goals," says Blaylock. Ask yourself, what's your next big target? Are you hoping to establish a college fund for your kids? If so, one option is to set up a 529 planthrough your brokerage firm. Do you have your eye on a dream item, like a vacation home? You should consider opening a separate savings account and send any excess income there.

What not to do after you pay off that balance

Unfortunately, it can be easy to fall back into debt. Blaylock has seen it happen with his clients: "They have denied themselves so much, and now that they can afford the new furniture/car/trip/wardrobe they've always wanted, they go overboard," he explains. "It's like being on a diet: You've been depriving yourself for so long that if you see cupcakes sitting there, you want to eat the whole box."

Ethan Saunders* paid off the last of his $38,000 of student loan debt in April, and although he's still in the clear, that feeling of temptation resonates for him. "The desire to live in the moment and overspend was squelched by knowing I had to make debt payments — it forced me to be on a budget," he says. "Once I paid everything off, I was afraid I might start spending too much again."

To prevent yourself from landing back where you started, think about doing a financial "postmortem." "It can be critically important to understand how you got into debt in the first place," says Klontz. "You should examine your underlying beliefs about money. Our unconscious financial attitudes are often passed down to us generationally, so looking at your family history can help provide incredible insight."

He advises having conversations with the people in your life who influenced you the most and asking them what they were taught about money growing up. For instance, if things were always tight when you were a kid, you might have developed an ingrained sense of not having enough — which in turn can lead to hoarder tendencies, or, on the other end of the spectrum, a splurge-happy mindset of spend-it-while-you-got-it.

Simply making the link between your money habits and their origin may even trigger a shift in behavior. "In many cases, that 'aha!' moment gives people enough perspective to start making changes," says Klontz. Another risk factor that tips some people back in the red is financial cluelessness. "After paying back loans for an extended period, you've learned how to be in debt, but you haven't learned how to save," explains Blaylock. To get a grasp on money management, you may need to start from scratch.

So begin preparing for the transition six months to a year before you're out of debt. Pretend that your debt payments are now money you can set aside, and use the guidelines above to figure out where to channel your funds. "Moving out of your financial comfort zone is like learning a new language: In order to become fluent, you need to study the culture," says Klontz. "You don't pick up a Frommer's guide when you get off the plane; you buy it before your trip. If you skip the preparation phase, you may run the risk of finding out that the most comfortable place for you to end up is back in debt."

You might also avoid the temptation to overspend by putting your credit cards on ice — literally. "We recommend freezing them in a bowl of water," says Blaylock, "but do not close the accounts because that could potentially damage your credit history." Or you can try a debit-card-only diet: Have a separate checking and debit card for your discretionary spending, turn off your overdraft protection, and feel what it's like to live off a budget. Once you've consistently budgeted for three to six months, you can consider using a tool like LearnVest to track spending, and a credit card that you pay off in full each month for rewards.

Osbourne was so worried about getting caught up in the slippery slope of credit cards that for a long time she had only a Visa debit card. "I have such a mental block toward credit cards," she says. "Finally, I decided to apply for a card that I'll only use for business purchases."

*Name has been changed.

This story was originally published on LearnVest. LearnVest is a program for your money. Read their stories and use their tools at LearnVest.com.

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