By: Joseph Goldy, AAMS®
When we help clients with their cash flow at Highland Financial, we pay close attention to credit card debt for a reason.
Spending on everyday purchases with a credit card to earn travel points or cashback is a great way to get rewarded for things you would typically be paying for anyway. However, the caveat is that a client must pay off their balances in full each month and keep their excess spending in check. Otherwise, any perk you receive from the credit card company will be quickly negated by paying exorbitant amounts of interest.
As financial transactions move further away from cash and more toward credit cards or contactless payments, the line between necessary spending and an impulse purchase begins to blur.
When we lose the psychological connection to physical currency, it becomes more difficult to regulate our spending. Credit card companies know this, as do casinos which is why they use chips rather than actual money.
According to a recent NPR article from 2020 citing a Federal Reserve report, credit card debt has hit an all-time high in the U.S. at $1 trillion, with delinquencies on the rise as well. The average American is carrying just under $7,000 in credit card debt.
Credit Card Debt is Not Usually Considered “Good” Debt
Debt itself is not necessarily good or bad; it’s how you use it that matters. Credit card debt is not typically viewed as good debt since it carries a very high interest rate and is used to pay for discretionary items which are not appreciating.
How Much Debt is Too Much?
The general rule of thumb for debt payments with interest that is not tax-deductible, such as credit card debt, is less than 20% of your after-tax income.
When looking at your total debt picture, including mortgage, car loans, etc., you should keep total debt payments to less than 36% of your gross income (when including mortgage debt, we use gross income since you receive a tax deduction for the interest on the mortgage).
If you find yourself with high credit card balances, there are options to help you pay it off.
Options to Help Pay Off Your Credit Card Balances
Balance Transfers
If your FICO score is around 700 or higher, you can likely qualify for a balance transfer offer to a new credit card that would potentially give you a window of time to benefit from 0% interest. A recent Google search brought up a 0% interest balance transfer offer for 20 months with several other offers at 0% for 18 months.
A person can save a considerable amount of money on interest payments if they pay off their balance in the 18-20 months provided. For example, if your balance were $10,000 with an 18% interest rate compounded monthly, you would save several thousand dollars in interest over those two years.
Debt Consolidation Loan
Debt consolidation loans are just as they sound, a single loan offering you the ability to consolidate several outstanding credit card balances into one lower-interest loan. The convenience of paying one bill is obvious, but the real reason to do this is to lower the interest rate you’re spending on the balances.
There are a few risks to be aware of with this strategy.
For one, it only makes sense if the interest rate you’ll pay on the loan is considerably lower than your current credit card rates. Despite credit card rates being high, often 18% or more, if the debt consolidation loan rate is also in the double digits, it may not be worth it for the amount you’ll save. Here too, the higher FICO scores will provide for more favorable rates.
Another risk is that if you are consolidating into a loan with a long term, the lower interest rate may look appealing, but when you do the math, you could wind up paying more over the entire duration of the loan. Be sure to run the numbers to see if the longer loan term causes you to be paying more in total interest.
Finally, if you obtain a debt consolidation loan and suddenly see zero balances on your credit cards, there is a real danger of running up the cards again.
A person needs to be honest with themself and ask why excess debt was incurred in the first place. If it’s because of impulse buying and lack of budgeting, you can quickly find your credit card balances back to where they were, on top of the debt consolidation loan payment as well!
The Snowball Technique of Paying off Debt
The snowball technique is a common method to help pay off several credit cards’ balances over time.
Here is an example to illustrate:
The snowball technique involves taking the extra amount that someone is putting toward their debt payments and applying that “extra” to the smallest outstanding balance.
For instance, from the above, this client would take the additional $25 going toward his Amex and apply that to the Mastercard monthly payment of $60. Same for the extra $25 he is paying each month toward his Visa, putting that toward the Mastercard as well.
So instead of putting $60 toward the Mastercard each month, they would be putting $110 ($60 currently + $50 redirected from Amex and Visa) toward that balance to pay off the card with the smallest balance quickly. When the Mastercard balance is eliminated, the $110 in cash flow can then be applied toward the American Express balance, and so on.
A variation of this is to apply extra cash flow toward balances with the highest interest rate first, then move to other lower interest debt to save on interest over time.
Whatever option you choose, tackling credit card debt begins with creating a budget, understanding your cash flow, and living within your means. Overspending will only get easier in the future as humans encounter physical currency less and less.
Working with your financial planner to eliminate this debt as quickly as possible will help ensure your plan stays on track.
Author’s Bio
Joseph Goldy, CFP®, is a wealth advisor and CERTIFIED FINANCIAL PLANNER™ at Highland Financial Advisors, LLC, a fee-only fiduciary wealth advisory firm based in Wayne, New Jersey.
Joe specializes in working with newly independent women because of divorce or losing a spouse. He understands firsthand the value of having a clear financial picture pre- and post-divorce and a plan to restate goals as a single person. When he is not helping clients, Joe enjoys spending time with his two sons outdoors and volunteering to help raise money for Type 1 diabetes organizations.