Paying Off Credit Card Debt Using Winter Weather Analogies

26. April 2012 · 10 comments · Categories: Credit Cards, Debt · Tags: , , , , , , , ,

For those struggling with credit card debt, coming up with a repayment plan can be a challenge. Should you focus on the highest-interest card or the one with the lowest balance? What if you have student loans or car loans mixed in? Dealing with so many different monthly payments at once can be overwhelming.

The Motivational Perspective

Which credit card you deal with first depends on two factors. First, there’s the psychological aspect. Many people tend to pay off the lowest-balance card first because of something known as “debt account aversion.” That is, we aim to limit the number of open accounts we have.

Paying off the smallest card first means one less account we have to deal with. Getting rid of one balance is a small victory, which gives us motivation to move forward with our plan. Experts have come up with a cute name for this strategy: Debt snowballing. The idea is that you build momentum by paying off smaller accounts first, then putting those payments towards larger accounts.

This path certainly makes sense from a motivational standpoint, but is it best for you wallet? You also have to consider the financial aspect of debt repayment.

The Financial Perspective

From a purely financial perspective, paying off the highest-interest card first makes the most sense. Using this method you’ll pay less in total interest to the credit card company and reduce the time it takes to repay the debt.

Let’s say you have two credit cards. One card has a balance of $8,000 at 19% and the other is $5,000 at 15%. Both have minimum payments of $40. Psychologically, you’d be tempted to pay off the $5,000 balance first to eliminate one of the accounts. But I’ll show you why this is bad for your wallet.

Making the minimum payment, it will take you over 10 years to pay off both balances. But since you’re on top of things, you have an extra $300 to put towards the cards each month beyond the minimum. Where should you put this extra money?

By paying $340 to the $5,000 card and the minimum to the $8,000 card it would take you 49 months and cost $5,575 in total interest.

On the other hand, by paying off the larger card first it’ll take you 47 months and cost $4,754 in interest. Focusing on the higher interest rate first saves you $821 and will take you 2 months less to pay off both balances.

You’re probably thinking that $821 is a lot of money, and you’d be right. But let’s say you cut back on eating out, giving you an extra $100 a month to put towards the cards. It will now only take you 35 months to pay off both balances, a full year less. Not only that, it will save you another $1,343!

Applying every bit of extra money you have each month to debt repayment is known as “snowflaking.” Snowflakes can come from anywhere – income from a side job or savings from decreased expenses.

Which Strategy is Right for You?

Your repayment plan should depend on your personality. If you’re very disciplined with money, focusing on the highest-interest card first is probably your best strategy. On the other hand, if you think you’ll need small victories as motivation to stay in the game, paying off low balances first (the snowball method) might be your best bet.

No matter which strategy you choose, your goal is the same: to pay off the debt. Having the numbers in front of you will only increase your focus. Use a debt repayment calculator like this one to help you build and track your strategy.

Which repayment strategy makes the most sense to you?

Photo by blog.austinkids.org

The 3 types of credit card users

12. December 2011 · 1 comment · Categories: Credit Cards · Tags: , , , , ,

The use of credit cards has grown steadily over the past few decades. More people are opting to pay for purchases with plastic over cash. And with online shopping credit cards have become the payment method of choice for most consumers.

When the bill comes due though, people vary in how they deal with it. People tend to use credit cards in 3 ways:

  1. For everyday purchases, then pay balance in full each month
  2. One-time life events charge up a balance in one transaction
  3. Lifestyle debt charged up over time

I’ll discuss each of these categories one at a time.

First, there are those who use credit cards mostly for convenience as part of their financial strategy. These are the folks who use plastic for gas, grocery stores, restaurant meals and other everyday purchases, then pay off the balance in full each month when it comes due. They typically set a spending limit for themselves, which is most likely lower than the actual limit of the card, and don’t go over that for the month. They have the self control to use only their own personal limit, which is set in advance and is based on their monthly budget. They may splurge once in a while, but impulse purchases are the exception rather than the rule and are paid for with savings. These types of users will benefit from rewards cards, which offer financial perks but typically have higher interest rates than other credit cards.

Next there are those who have an unexpected event occur in their lives and charge it to the credit card. They most likely don’t already have an emergency fund to draw on when the unexpected happens. Events such as car accidents, medical bills, or the birth of a child fall into this category. This debt isn’t lifestyle debt, which occurs as a result of living above your means. Rather, a lack of advance savings is usually to blame.

Finally there are those who live beyond their means on a regular basis. They spend what they earn and then some. People in this group may see a leather recliner while out shopping that would look perfect in the living room corner. They may decide to purchase a new $800 laptop with no money saved up. Or they may buy some expensive jewelry for their significant other. They won’t think twice about charging it to the credit card. When the bill comes they may even be afraid to go to the mailbox to see what’s waiting for them.

For those in the last group, a lack of self-control is usually to blame for their spending habits. Incurring debt for optional expenses is never a good idea. Plan for these items instead by setting up an automatic transfer into a saving account each month until you reach your goal. This allows you to avoid paying the high interest rates that come with credit cards. If you begin to pay down the balances on your credit cards but still feel the temptation, it’s best to cut up the cards and use cash only. It may be more inconvenient, but it will save you from crushing levels of debt later on.

In my opinion, only those who pay off the balance in full each month benefit from using credit cards as part of their strategy. To cover the cost of unexpected expenses build up an emergency fund to get you through. And for optional purchases, the best strategy is to save up first.