Being smart about credit card debt can help the average investor bank a guaranteed 18%. It is a conscious decision that could save the average household approximately $1,500 a year. So how can you bank these savings? Read on for tips from financial experts on how to tackle debt and grow you savings.
The Debt Dilemma
Let's say you owe $5,000 on your credit cards and are paying 18% interest. The credit card companies, which of course like having a steady stream of revenue, might ask you to make a minimum payment of $150 a month. But just making a minimum payment will result in years of debt.
Assuming you make no new purchases and pay a fixed $150 each month for the next several years, how long will it take to pay off the $5,000 debt? Three years and 11 months. You will also end up paying approximately $2,000 in interest. That's a lot of money to pay for credit.
Average Household Credit Card Debt
In relying on credit cards, some people throw away tens of thousands of dollars over decades.
As of 2007, the median amount of credit card debt carried by the average American household was $6,600, according to CardTrak.com. There are millions of cardholders who carry what advisors would say are dangerous amounts of card debt.
"No matter how you slice or dice it Americans owe a signific amount on their credit cards," says Robert McKinley of CardTrak. He estimates the average American household pays some $1,500 a year in credit card interest.
Lewis J. Altfest, a certified financial planner in New York whose clients tend to be professionals with large incomes says that "to financial planners, debt often represents risk. Too frequently, [financial planners] see abusive use of credit leading to financial difficulties. They recommend that debt be limited to investment items such as the purchase of a home," Altfest writes. That's because credit card debt, unlike some other kinds of debt, is not tax deductible.
For example, credit incurred in the purchase of a home, which is an asset that usually can be resold for a profit, can often be used as a tax deduction. The government is, in effect, helping to underwrite your purchase of an asset. On the other hand, interest incurred on a loan to buy a car or run up credit card debt is generally not deductible. (For more on this, read The Mortgage Interest Tax Deduction.)
Credit card interest is also very expensive compared to other debts. That's because card interest, on average, is about twice the nominal interest rate as the home equity loan or mortgage. (To learn more, read Understanding Credit Card Interest.)
|Watch: Prioritizing Debt|
The credit card debt that many people carry also presents an opportunity for considerable savings. Eliminated credit card debt can free up money that could be devoted to everything from luxury to investment. Advisors also say that there is a guaranteed investment opportunity. An easy way to earn 18% or better is to get rid of credit card debts as soon as possible.
How to Attack Credit Card Debt
"Let's say you have four credit card debts. The first thing I would recommend is to categorize all of your debts," said Charles Hughes, a Certified Financial Planner® in Bayshore, New York. (For more on this see, Take Control of Your Credit Cards.)
"Instead of making four equal payments on all of the cards, consider making the biggest payment on the card with the highest interest rate." Hughes also said that as you reduce debt, you should keep a cash reserve to avoid running out of money. Otherwise, after running down a credit card debt, you could quickly fall back into the red. (To learn how to build this reserve, read Build Yourself An Emergency Fund.)
Set goals for yourself, Hughes says. Have a realistic plan to eliminate the debt as soon as possible. "Also, make a list of where your money is going," he adds. In making what Hughes calls a "cash flow analysis", superfluous spending can often be spotted.
Also avoid new debts that will pile on the existing ones. Put cards away for a while and try to pay for daily purchases in cash. (For more on making this budget, read The Beauty Of Budgeting.)
As debt declines and one starts achieving goals, "a person will become enthusiastic about eliminating more and more debt," Hughes said. He added that the same techniques can be used to build up savings, but credit card debt should be eliminated first.
Making Cards Work for You
Once you have gotten out of the habit of paying interest on cards, there is a way to make cards work for you. However, the credit card companies expect that most people won't use this technique.
Most cards "provide the consumer with an interest-free loan from the date of purchase to the date of the billing," writes David Evans and Richard L. Schmalensee, credit card industry analysts. That means the card company has extended you an interest-free loan. However, remember that this grace period generally does not apply when you take a cash advance on a credit card, which is probably the most expensive way of accessing credit.
Card companies, which are under pressure to obtain as much business as possible to survive, refer to the sage cardholders who pay off balances each month "transactors".
So why do companies offer them free loans?
Because they know that many customers will be "revolvers". In other words, most people will carry some kind of credit balances from month to month, which is the main way the credit card companies make their money. The card companies also try to get as many revolvers as possible and (of course) hope that some transactors will become revolvers, too.
Generally, transactors tend to be those with higher incomes. For example, Altfest, who works with high net worth clients, says he spends a lot of time counseling clients on how to use credit safely.
"Sometimes people just get in too deep. They eat dinners at expensive restaurants three or four times a week and I try to get them to put some limits on their use of cards," he said. In this case, he advises clients to cut back on luxury expenses.
How do you know when you have a problem?
Howard S. Dvorkin, a Certified Public Accountant and founder of Consolidated Credit Counseling Services, says that financial advisors generally suggest that the average person shouldn't be paying more than 10% of net take-home pay on credit card and other consumer debt.
"These same financial experts also advise that however much debt you have, you should be able to repay all of it within 12 to 18 months," Dvorkin writes in his book, "Credit Hell: How to Dig Out of Debt" (2005).
Saving $1,500 a year in credit card interest may not seem like much - and it probably isn't over the short term. But over the long term, it's huge; over 30 years, it adds up to $45,000 in interest savings.
Let's say you took $100 per month ($1,200 per year) of that $1,500 and invested it in a mutual fund that earned an average rate of return 9% per year.
At the end of 30 years, you would have roughly $184,000 before taxes. That's $184,000 just because you started using credit more intelligently and invested your money instead. In our example, the difference between $45,000 of credit card interest over 30 years and the amount gained by investing can be substantial.
For most individuals, a savings of $45,000 over 30 years could make a big difference. Think of the opportunities for productive use for that money! For those with a credit card debt problem, eliminating it could be the best chance over the course of 30 years to build up savings and investments. Being smart about credit card debt is one surefire way to increase wealth over the long run.
That's quite an investment!