Episode 145: August 17, 2010
Debt Loans Credit
By Laura Adams
Recently I’ve received several questions from listeners about how to deal with their credit card debt. The most common question is about how to decide which cards to pay off first and how much to pay. Like this voicemail:
“Hi, my husband and I are piled under credit card debt and we have an opportunity to dip into our savings accounts to take care of at least one or two of the credit cards. And with the economy the way it is now and instability with jobs, we’re wondering if we should just pay off the smallest balance with the highest interest rate or pay 50% of the balance down on one or two, or even three of the credit cards, or just keep paying the minimum payment. Paying down some of the credit cards will free up some more money to do other things with. Thank you.”
The caller didn’t give her name, but whoever you are, thanks for the great question! In this show I’ll give you a smart strategy to use when tackling your credit card balances.
How to Decide Which Debt to Pay Off First
Figuring out how to tackle your credit card debts can be challenging. But if you’re like the caller and are determined to get them under control, congratulations! Paying down credit card debt or eliminating it altogether will save you a heap of interest. I’m sure you’ve got better uses for your hard-earned money than sending it to a bank, right?
Whenever you make a decision to pay down debt, it’s wise to look at the “big-picture” of your financial situation. Before you withdraw money from your savings account to pay down a credit card, the first order of business is to pay off any other debt that should take priority. That might include something serious like a tax delinquency, a legal judgment, or unpaid child support, for example. Those types of debts can be a one-way ticket to the lockup, so always take care of them first! The next debts to pay off are those that are already in default or have been turned over to a collections agency.
Before you withdraw money from your savings account to pay down a credit card, the first order of business is to pay off any other debt that should take priority.
Why You Need an Emergency Fund
Assuming that you don’t have any debts that are in default, your next consideration should be your emergency fund. Ask yourself if taking money from your savings to pay off a credit card would leave you with enough. I recommend keeping a minimum of six months worth of living expenses on hand. If you missed shows 114 and 115, listen to them for more information about emergency funds and the best places to put your reserve cash.
The caller mentioned the reason that having an emergency fund is so important--uncertainty about the economy and job stability. However, even when the economy turns around and the unemployment rate decreases, I’ll still recommend that you keep a six month emergency fund. If using a portion of your savings to pay down debt would still leave you with a healthy reserve fund, then by all means, go for it. But if you don’t have enough saved, stay focused on building up your emergency fund first.
Which Debts Should You Pay Down First?
The next issue is to decide which debts to pay down and in what order. It’s helpful to make a list of all your loans, lines of credit, and credit cards and their interest rates. Loans that come with a tax deduction such as mortgages, home equity lines of credit, and student loans, should be paid off last. Besides, those types of debt usually have relatively low interest rates.
The quick and dirty tip is to pay off debts with the highest interest rates first, such as payday loans, retail charge accounts, and credit cards. That’s because the higher a debt’s interest rate, the more it costs you in interest per dollar of debt. It’s possible that your credit card isn’t the most expensive debt you have. Look carefully at the annual interest rate for all your liabilities and target the highest one. If you’re like the caller and have several credit cards, evaluate them the same way--tackle them in order of highest to lowest interest rate. That will give you the most bang for your buck.
Should You Make the Minimum Credit Card Payment?
Many people make the mistake of thinking that paying a credit card’s minimum payment is good enough. The problem with just making minimum payments is that they go mostly toward interest and don’t reduce your actual card balance very much.
Here’s an example: Let’s assume your credit card has a 15% interest rate, you have a balance of $5,000, and that you never make another purchase on the card. If your minimum payment is calculated at 4% of your balance, it would take you 10½ years to pay off the card. And here’s the worst part--you would have paid almost $2,400 in interest!
Wow, think about what you could have done with that money instead: made investments, taken a vacation, or bought some really nice shoes.
Answer to the Caller’s Question
So here’s a summary of my answer to the caller’s question: If she has no other pressing debts and has at least six months of living expenses saved up, she should use her excess money to pay off her highest-interest debt. If that happens to be one of her credit cards, she should pay off the balance with the highest interest rate first, even though as she mentioned, it’s the one with the smallest balance.
The caller noted that paying off some of her credit cards will free up money to do other things. That’s the beauty of getting rid of high-interest debt. Once she pays off some or all of her high-interest credit cards, she’ll have more money available to pay down other debt or to save for the future.
For more information and tips about how to get out of all kinds of debt, be sure to get my newest audiobook, Money Girl’s 10 Steps to a Debt Free Life. It’s available at Audible.com, Amazon.com and in the iTunes store. Find links to the sale pages in the show transcript at moneygirl.quickanddirtytips.com.
Understanding credit cards and how to use them is to your advantage. On next week’s show I’ll give you tips about how to use balance transfer credit cards as a tool when paying down debt, and where to find the best one. After that, we'll look at canceling credit cards and whether or not doing so can hurt your credit score. Down the road, I'll tackle how you can find the best rewards credit cards.
And one more thing: Be sure to check out the newest Quick and Dirty Tips show,
The Dealista. Listen to show number 7 to find out how to get the best deals on Craigslist.
I’m glad you’re listening. Chi-Ching, that's all for now, courtesy of Money Girl, your guide to a richer life.
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