Managing Credit Card Debt

As a continuation of credit card month, I thought I would write post answering one of the more frequently questions I get asked. What is the best way to get out of credit card debt?

Before diving into what I believe to an effective way to manage this type of consumer debt, I want to first make the distinction that this post is solely focused on credit card debt. Some of these techniques can be applied to paying off other types of consumer debt like auto debt, student loans and mortgages but not all of them. Please, please, please do not read this post and takeaway the idea to consolidate your student loans onto a credit card. One, I plan to dig into student loans in the months to come. Two, everyone’s personal debt situation is different.

Now back to our regularly scheduled programming. What should you do if you have outstanding credit card debt?

Step One: Stop the Bleeding

If you find yourself racking up a credit card balance that you are unable to pay off at the end of the month, those balances start to accrue interest that will only make it harder to pay down the account balance. Credit cards are notorious for carrying high rates of interest (think 25% +) which can really slow down the debt repayment process. If you find yourself with a credit card balance on a card with a high interest rate, the first step is to stop the bleeding that comes from accumulating additional interest on the balance.

The most effective way to stop the bleeding is to stop using the card. Plain and simple but not always realistic. One way to stop using the card with an outstanding balance is to open up a second credit card. I know what you’re thinking, how is that sound financial advice. Stick with me for a moment, we will get there.

Balance Transfer Cards

This second credit card is not your average credit card from a local retailer. The type of credit card I am proposing is commonly referred to as a balance transfer credit card. It get’s this name because it allows the credit card holder to transfer and consolidate any outstanding credit card balances onto one credit card and new interest rate schedule. Balance transfer credit cards often offer very low (sometimes 0%) interest rate for new account holders for an introductory period of time.

Transferring balances from a credit card environment with 25% interest into a new environment with 0% interest is a very effective way to stop the bleeding. Be sure to read the fine print and understand the terms to the introductory period and any re-capitalization of interest that would occur if the credit card balance is not paid in full before the introductory period expires.

Note that in order to apply for and open this type of credit card you will need to have a strong credit score. Unfortunately, if your credit score does not fall within the “credit needed” guidelines a balance transfer strategy will not be an option.

To find the right balance transfer card for you based on your credit score you can use one of the websites below to research your options:

Switch to Debit

If after doing some research you learn that your are not eligible or do not quality for a balance transfer credit card, no need to fret. The other way to stop the bleeding is to stop using the credit card all together and limit yourself to using a debit card to pay for your essential and non-essential expenses. Debit cards are linked directly with a checking account which presents another good reason to have a fully funded emergency fund.

Stopping use of the credit card that got you into trouble will accomplish a few things. One, by not using the card your outstanding account balance will remain level (besides accruing interest), as will your credit utilization rate. Circling back to this post on credit scores, having a credit utilization below 30% will help to improve your credit score. Finding ways to help improve your credit during this time will improve your chances of eventually qualifying for a balance transfer credit card and implementing the strategy outlined above.

The second reason to stop using the credit card is to keep the interest on the outstanding balance from accruing at more rapid rate. The higher the outstanding balance, the quicker the interest will compound and grow. Just like the Rule of 72 determine how long until an investment doubles, the same logic can be applied to debt balance. The Rule of 72 will also calculate how long until a debt balance will double in size due to interest.

As an example, if you have $5,000 on a credit card with 25% interest rate, using the Rule of 72 it would take just under 3 years for that balance to double to $10,000 absent of debt repayments. This does not take into consideration minimum debt payments made along the way but illustrates the gravity of a 25% interest rate.

Step Two: Revisit Cash Flow & Budgets

Once you’ve found a solution to manage the interest rate on your credit card, the second step in this process is to reevaluate your everyday expenses. Running up credit card debt should signal that something is amiss on your budgeting and overall cash flow management. The most common issue is that expenses are outpacing income, an equation that needs to be realigned.

There are two ways to balance this equation, you can either control your expenses or control your income. Most people would say that it’s easier to control their expenses but I recognize that is not always the case.

Let’s focus first on the expense side of this equation. A great place to start your cash flow management is by listing out all essential expenses and then listing out all non-essential expenses. This can be done in an Excel document (my personal favorite), Word or on a piece of paper. What’s important to capture is a list of all areas of spending in one place and differentiate between fixed and discretionary expenses. You can use the graphic below if you need help determining which expense falls into which category.

Essential Expenses

Once you’ve made your list of expenses, go ahead and tally up your essential expenses. We will circle back in a moment to non-essential items but for now lets focus on the essentials. How much of your income goes towards these expenses? A rule of thumb that I share with my clients over and over is that 50% is a good target to shoot for.

What is your number?

If at this point in the exercise, your essential expenses are greater than 50% or come close to exceeding your income you should take a moment to evaluate these expenses to see if there is an opportunity to make reductions. Maybe your rent/mortgage is too high, could your move or refinance your mortgage. What about your car payment maybe you don’t need a brand new car?

If you are unable or unwilling to make adjustments within your fixed expenses then you might want to reevaluate your income. Do your skills qualify you for a higher paying job? Could you pick up a few shifts somewhere after work? What about an income producing side hustle?

Non-Essential Expenses

Now it’s time to circle back to those non-essential or discretionary expenses. I’ve found this is the area of spending where most people get into trouble. First step is to identify how much money you have “left” each month after paying for the essential expenses you outlined above.

As an example, if your fixed expenses represented 60% of your income. Your non-essential spending should represent close to 40% of your take home pay. How do they compare?

My guess is that you’ll find that your monthly non-essential spending or best guess at these expenses exceeds the rest of your income. If this is the case, take a minute and let that sink in. You’ve been spending above your means which has likely caused the credit card debt. You know what they say, the first step is acceptance.

The silver lining in this scenario is that we are talking about expenses that are not essential which means you have total control over these expenses and the ability to make changes that allow you to to re balance the income and expense equation.

One way to start this process is by revisiting your income and carving out 10% of income from your discretionary expenses and mentally move it to the side (more on this in a minute). In this example, that would leave us with 30% of income to cover all non-essential expenses. Calculate this amount and determine how to best allocate it between your non-essential expenses. That my friends, is creating a budget.

Step Three: Create a Repayment Plan

At this point, you should have a strong understanding of your spending and the changes that must be made to have enough funds to begin repaying the credit card debt. Depending on the outcome of the exercises above, these changes could be cutting back on non-essential expenses or finding a part-time job to put towards the credit card payments.

The trick to paying off credit cards in a timely manner is to pay more than the minimum payment. For this reason, you’ll want to use that 10% of income you held to the side towards making meaningful payments towards your credit card balance.

Example Recap:

Income = 60% Essential Exp.+ 30% Non-Essential Exp. + 10% Debt Payments

If you just have one credit card to pay-off the process at this point is pretty simple. Each month continue to put the amount you’ve designated from each paycheck towards paying off the credit card until eventually your balance is paid off in full.

If you find yourself with multiple credit card balances, there are two debt re-payments strategies that have been proven successful over the years. The first place to start is to inventory your various credit card balances and interest rates.

Avalanche Approach

With both the avalanche and snowball approaches, the basic concept is making the minimum payments on each debt balance and then taking extra funds, as determined in the exercise above, to target paying down one credit card balance at a time.

In the avalanche approach, is unique in that the payee puts the extra credit card payments towards the balance with the highest interest rate. The reason it’s called the avalanche approach is because by focusing on knocking out the debt with the highest interest rate, the payee will save the most from an interest perspective. It gets the term avalanche because you are tackling the most expensive debt first which has the most impact on a person’s financial situation.

Snowball Approach

The snowball approach differs from the avalanche approach in that it targets paying off the smallest debt balances first, irregardless of interest rates, and then tackling the next biggest balance and so on. The idea is that getting a small win from paying off a small balance will create positive momentum that will create a snowball effect. Think of a snowball rolling down a hill, it starts small but gradually gets bigger as it gets to the bottom of the hill and picks up speed. It’s a visual representation of the order of which paying off the debt balances. While this is not mathematically the most efficient way to settle debt, it can be the most effective in keeping payee’s enthusiasm high during the debt repayment process.

Hope you are able to walk away from this post with some new ideas on how to approach cash flow management or debt repayment strategies. If you have questions specific to your financial situation, feel free to reach out.

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