Credit And Debt Management: Reducing Debt
by Cathy Pareto
The portion of disposable income that American families devote to debt is higher than ever, according to the Federal Reserve. Unfortunately, the pace at which Americans borrow their way through life is simply unsustainable, and a good testament to this fact is the global credit crisis of 2008. Of course, there is not much that we can do as individuals to bail a country out of debt, but there is much that we can do to bail ourselves out of it.
The first step in your debt-liberation plan begins with banning any further charging on your cards. While we do not suggest that you close your accounts (as this may impact your credit score negatively, we do recommend that you either cut up your cards or lock them away in a safe place so you are not tempted to use them. (Find out the consequences before deciding to end your credit agreements in Should You Close Your Credit Card?)
Conquering the debt beast requires organization and discipline. Therefore, the next step in your debt-liberation strategy should be a budget. A budget is not intended to deprive you; it's intended to guide you and help you monitor your spending. People from all walks of life and of all socioeconomic levels need and use budgets. Keeping a budget is one of the most effective methods to build wealth and control debt. (For more on creating your budget, see our Budgeting Basics tutorial.)
In preparation for creating this budget, make a list of all the credit card amounts you owe, the annual fees you pay, your current minimum monthly payments, and the interest rate and credit limit associated with each card. List your highest-interest card at the top, as this will be a priority in your debt-payoff strategy. Your list should look like the following:
|Card||Annual Fee||Interest Rate||Monthly Minimum||Total Balance|
Then, determine an amount that you can commit toward paying off your credit cards each month. This number obviously should be higher than your total monthly minimum required payments. You can most effectively determine this amount once you have created a list of all your other monthly expenses.
The Waterfall Method
Once you've determined how much you will allocate to consumer debt payments, use the waterfall payment method to pay off your debt. Attack the highest-rate cards first (making the required minimum payments on the rest of the debts). Some consumers may be tempted to pay off the cards having the smaller balances first because it seems easier, but attacking the highest-rate card first makes the most financial sense since that card is costing you the most in interest payments. Once the first card is paid in full, then use what you were paying toward that card and "roll it down" to the next-highest-rate card.
For example, if you have three credit cards each with a $3,000 balance but with rates of 21.9%, 16.8% and 9.9% and payments of $300, $150 and $150 respectively, once the 21.9% card is paid off, you would reallocate those $300 payments to the card with 16.8% interest for a new total of $450 to that card and the same $150 to the card with 9.9%. This is also called the "roll-down method".
This process may take months or years to complete, depending on the amounts owed. But with sufficient patience and discipline, it is an effective method to free you from the shackles of debt. (Learn how managing your debt could mean the difference between spending $45,000 or saving $184,000 in Expert Tips For Cutting Credit Card Debt and The Indiana Jones Guide To Getting Ahead.)
Finally, it is worth considering any annual fees you are paying for your credit cards. You may find that some of the cards that charge an annual membership fee offer you the best rates and/or perks. For those who are attracted to certain credit card perks, such as premium travel benefits or advance concert ticket sales, the annual fee might be worthwhile. Some cards, however, charge an annual fee with no corresponding benefits, and it's up to you to decide if you're willing to pay that much for access to credit.
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