Dear Debt Adviser,
I have $30,000 in credit card and personal loan debt -- $20,000 in personal loans at 10.99 percent and $9,500 in credit cards at 5.99 percent. The only problem is the personal loan comes with a fixed payment of $560 a month. I want to pay down my debt using my $6,200 tax refund. Which account should I pay? The bank for the personal loan keeps reducing my credit line every six months to just a few hundred dollars above what I owe. If I put that $6,200 toward the personal loan and lower the loan to $13,800, and they lower my credit line again to just above $13,800, will it hurt my credit score? Thank you.
-- W.
Dear W.,
I hate to be the one to tell you, but your only problem is not that your loan has a fixed payment of $560. You have $30,000 in unsecured debt and a lender that is lowering its exposure to you every chance it gets. As lending professionals, by lowering your limit as soon as you make a payment, they are telling you that you are overextended in their eyes. As a debt and credit professional, I am telling you that $30,000 is way too much unsecured debt to be carrying.
I would much rather see you concentrate on paying off your $30,000 in debt than on how well your credit score is doing. Don't get me wrong, a good credit history is important for many reasons, but a slight dip in your credit score shouldn't even be on your radar right now. Plus, in your situation, your score is already blemished by having a loan outstanding that is virtually 100 percent of your credit line maximum. And it should be blemished! You are in risky territory and your score should be showing it.
Well, now that I got that off my mind, let's look at some options. Going by the numbers, as long as you don't have any early payment penalties on your personal line of credit, you would save about $2,000 in interest charges if you paid down your personal loan by $6,200. Plus, it would pay off 15 months faster. If you are making only the minimum payment on your credit card, you would save about $1,800 in interest charges and pay it off eight years faster by applying your $6,200 to the balance owed. However, I hope you are making more than a minimum payment on your cards each month. With a consistent monthly payment of $200 on your card, you would save $1,200 in interest charges and pay off the balance three years earlier if you decreased your balance by $6,200.
Before the Credit Card Accountability, Responsibility and Disclosure Act of 2009, or CARD Act, I would have advised you to pay off the credit card in a heartbeat. Now that you don't have to worry about universal default interest rate increases (increasing your interest rate for any reason), you can make the decision based on what's best for your finances. It might be best for you to free up money monthly as quickly as possible. If that is the case, use your tax refund to pay your credit card and you can pay off what you owe in 18 months with a payment of $200 a month.
Before I close, I do want to congratulate you on using your tax refund wisely and paying down your debt. Many people waste a good opportunity to leverage their tax refund to improve their finances and instead blow it. However, one last thing, if your situation hasn't changed from last year, increase your number of deductions with your employer so that you reduce your income tax withholding by at least $400 a month. Use that extra monthly income to pay off the remainder of your debts. It is much better to receive that money each month and use it to pay down debt that's costing you interest. As it is now, you are giving Uncle Sam an interest-free loan of $6,200 for a year.
Good luck!
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