Credit cards can be a huge convenience. But if you aren't careful, they can also be an easy way to get into serious financial trouble and end up with bad credit. Here are a few reasons you might want to cut down on your credit card debt and some simple steps for going about it.
- Credit card debt is expensive and having too much of it can hurt your credit score.
- To reduce your credit card debt, plan to pay more of your balance each month, ideally all of it.
- If you have several credit cards, try to pay off the one with the highest interest rate first.
Downsides of Credit Card Debt
There are a lot of good reasons to carry less credit card debt, or even none at all. Among them:
Credit card interest is very expensive compared with other forms of debt. In fact, card interest, on average, runs about twice or three times the interest rate for a home-equity loan or mortgage. It can also take a big bite out of your budget. Financial advisors generally say the average person shouldn't pay more than 10% of their net take-home pay on credit card and other consumer debt (not including mortgages), notes Howard S. Dvorkin, a certified public accountant and founder of Consolidated Credit Counseling Services. More than that and you may have a problem making other ends meet.
Lewis J. Altfest, a certified financial planner in New York whose clients tend to be professionals with large incomes, says credit card debt often represents a risk. It can also be an early warning sign of trouble ahead. "Too frequently, [financial planners] see abusive use of credit leading to financial difficulties," Altfest writes. "Sometimes people just get in too deep."
It Isn't Deductible
Unlike some other kinds of debt, credit card interest is not tax deductible. By contrast, the interest you pay on a home mortgage typically earns you a deduction.
It can Hurt Your Credit Score
One factor credit that bureaus use in computing your credit score is called your credit utilization ratio. That's how much money you currently owe, as a percentage of all the credit you have available to you. For example, if the limits on your credit cards total $15,000 and you owe $5,000, your credit utilization ratio is 33%. Generally speaking, a credit utilization ratio greater than 30% is considered a negative in credit scoring.
How to Attack Credit Card Debt
If you want to reduce your credit card debt, here are some of the steps you can take.
Pay More than the Minimum
Let's say you owe $5,000 on a credit card and are paying 15% interest. Your credit card company might allow you to make a modest minimum payment, such as 2% or your balance, or $100 a month. But just making that minimum payment will result in years of debt and many hundreds of dollars in added interest.
Assuming you make no new purchases on the card and pay that $100 minimum each month, how long will it take to pay off the $5,000 debt? The answer is 79 months, or more than six and a half years. years. You will also end up paying close to $2,900 in interest. That's a lot of money to pay for borrowing $5,000.
Pay Down Your Cards in Order
"Let's say you have four credit card debts," said Charles Hughes, a certified financial planner in Bayshore, N.Y. "Instead of making four equal payments on all of the cards, consider making the biggest payment on the card with the highest interest rate." After you've paid that card off, move on to the one with the next highest rate.
This technique is called the debt avalanche, and it's the most financially efficient choice. It contrasts with the other payoff strategy, the debt snowball, in which you completely pay off the smallest debt first (paying just minimally on the others). Then you use your extra money to methodically pay off the rest of your debts from smallest to largest. This gives the psychological benefit of reducing the number of debts you owe through a series of smaller victories, until the biggest one is the only one left.
One way to stop racking up credit card debt: Start using cash more often.
Avoid New Debts
Put your cards away for a while and try to make your daily purchases in cash. This could also be an opportunity to do a cash-flow analysis to figure out where your money has been going, Hughes notes. You will probably spot unnecessary spending that you can cut back on, and save all the more.
Transfer Your Balances
You may be able to transfer your balances from high-interest cards to lower-interest ones. Such offers often come with a 0% introductory interest rate for six to 12 months. Enticing as that may sound, there are some caveats. For one thing, transfer offers tend to require an up-front fee of 3% to 5% of the amount you're transferring or else a flat balance transfer fee. Even so, it could be worth it, especially if you use one of the best balance transfer cards available.
Consolidate Your Debts
You might also take out a personal loan or line of credit to consolidate your credit card balances (and other debts) at a lower interest rate. With such a strategy you could conceivably convert card debt on which you're paying 15% or more in interest to a loan with an annual percentage rate more in range of 4% to 8%. Just remember to bank what you save on interest rather than spending it to increase your debt, and be sure to compare different personal loans in order to find the best one for you.
You may also want to work with a debt relief or settlement company to help you reduce the amount of outstanding debt.