This is a guest post from Andrew Selby. Andrew writes about debt management programs at his Debt Consolidation Blog.

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After fighting, scratching and clawing for years, I had finally paid off my college loans and was completely debt-free. I achieved what most people think is impossible. Debt had put my life in the camel clutch, and I had finally managed to break the hold. Then, just when I thought I had conquered debt, I let my guard down.

I’m debt-free!

After the first few months of living my debt-free lifestyle, I let the “free” part go to my head. If I wanted some new clothes, I didn’t think twice about charging them to my credit card. Why not, right? I was debt-free. I could just pay the balance at the end of the month.

Then, a few weeks later I would find a piece of furniture I wanted. No big deal, right? I’ll just charge it now and pay off the balance later. After all, I’m debt-free.

After a few months of making these types of poor decisions, I realized that I had piled up a few thousand dollars in credit card debt. Whoops! It was no problem, though. I had already paid of over $40,000 in student loan debt, so what’s a few thousand?  So I would hunker down for a few months until I had all zero balances. Then I would revert right back to my debt-free mentality and repeat the cycle.

I went through this cycle about eight times over three years before I realized that, despite being technically debt-free, I still wasn’t any further ahead than when I paid off my debts for the first time. That is when I realized that in order to manage my money responsibly, I would have to limit my access it. I was never going to be able to make good decisions in the face of temptation. I’m just not that responsible.

I’m not alone!

As I began to see that I was trapped in a rat race that I wasn’t going to be able to get out of, I also noticed how many other people were doing the same thing. My girlfriend, who has since become my debt-free wife, confessed to me that despite paying off over $10,000 in credit card debt, she had charged herself right back up to the same amount.

Everywhere I looked, I saw people who were trying so hard to get out of debt making the same mistakes I was making. There appeared to be many people, just like me, who would get to the end of the month and wish they hadn’t charged those fancy dinners because they didn’t have enough left to pay the electric bill.

Maybe a budget will help!

Like any smart, ambitious, personal finance student would do, I concluded that I would have to write out a monthly budget. However, this didn’t help to address my core problem. I am just not responsible enough to stick to a budget. I just can’t say no to spending, even though I should be saving the money for bills.

Ding! That was the answer! I just need to keep as much of my income as far out of reach as possible! Thus, the Waterfall Money Management System was born.

The Waterfall Money Management System

The simple idea of my Waterfall System is that the less money that I allow myself access to, the less money I can blow on unnecessary expenses. Here’s how it works:

Three expense categories

The first thing I did was separate each of my monthly expenses into one of three categories. Since I already had a monthly budget, this was pretty easy.

The first category was the most important. This was all of my debts that needed to be paid off. After I paid off all of my debts for the last time, this category became my savings, investment, and retirement money.

The second category contained all of my living expenses. This included my mortgage payment, utilities and cable bill. These were expenses that were necessary to provide my budgeted lifestyle and could be reasonably estimated each month.

The third category was all other expenses, which I considerd non-necessities. This included groceries, clothes, restaurants, entertainment and other such things. (I understand that food and clothing are in fact necessities, but I have a habit of rationalizing overspending on those items, hence I group them as non-necessities.)

I broke down how much I made and calculated the average cost of each of my expenses. This proved my suspicion that I was simply overspending on non-necessities.

The key component

None of this was very significant up to this point. All I had done was put together a categorized budget and prove that I was living above my means. How could I force myself to cut back on my excess spending?

The idea actually came to me completely by chance. All in the same day, I was struggling with my personal budget issues, was asked to open a free checking account at a local bank, and was updating the direct deposit information for an employee at work.

I realized at that moment that I could open separate checking accounts for each of my expense categories. I could then calculate the monthly cost of each category and set up my paycheck to be directly deposited into three different accounts based on priority. This idea would have my income flowing through the accounts in order, much like a waterfall.

The first priority was my debt payment plan, which was a fixed monthly amount, so I would designate that amount to come off the top of my paycheck and go into the first bank account. The second priority was my standard, budgeted living expenses. I set the average cost of those bills, plus a little extra just in case, to be taken from my paycheck into the second account. Then I had whatever was left of my paycheck put into the third account for the rest of my expenses.

The first two accounts have no debit cards or checks. Every single expense is automatically debited from the accounts each month, so the entire system runs independent of me. (An added bonus has been that I have not been charged a late fee since switching to this system!) I simply check the account weekly to make sure that the bills are being debited correctly. If there is ever a problem, I transfer money from my free spending account to cover the difference, but never the other way around.

I have a debit card for the third account, but prefer to withdraw the cash and spend it as needed. Since I am paid on a weekly basis, I only have to budget for seven days, which is very manageable.

Two years later

Early on in my adoption of the Waterfall Money Management System, I realized that there was one major flaw: It was too easy to jump onto my bank website and transfer money between my accounts. Before this had the chance to sabotage my plan, I came up with a simple solution: use different banks.

Today, my debt payment account has become a nicely funded savings account with a local credit union. I have set this account up so that the only way I can withdraw money is to physically go to the credit union during banking hours. This has prevented countless late-night bad decisions.

My other two accounts are with two different local banks, so there is no interaction between the accounts. If I have an unusually large electric or gas bill, I simply withdraw some money from my free spending account and put it into my bill-payment account.

Limiting the amount of my money that I have access to has completely changed my life. For years, I would lay awake in the middle of the night worrying about how on earth I was going to make whatever payment was due that week. Now, I honestly haven’t worried about missing a payment in years. Everything is handled for me before I have a chance to mess it up. It has brought an unbelievable peace to my life. I now know how it truly feels to be debt-free!

Have you used a money management system like this? Which system works best for you?

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