How to break the credit card debt cycle
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This week, the Federal Reserve raised the federal funds rate by 75 basis points. Cumulatively, the Fed has raised rates by 300 basis points (three full percentage points) since March. As a result, in the coming weeks, there’s a good chance your credit card statements will show rates that are three percentage points higher than they were at the start of the year.
Even before this week’s hike, the average credit card APR (18.16 percent) was at its highest point since 1995. In the coming months, there’s a very good chance the average rate will top 19 percent. The highest average in our database which stretches back to 1985 is 19.00 percent in July 1991.
This is making it even harder to get out of debt. About half of credit card holders carry debt from month to month, and 60 percent of them have been in that position for at least a year, according to a recent survey commissioned by our sister site CreditCards.com. That’s up from 50 percent last year.
Credit card debt is a persistent problem for many families. Contrary to popular opinion, it’s not usually caused by a shopping spree or a vacation or some other frivolous, discretionary purchase. The CreditCards.com survey found that the most common reasons that got people into this predicament were emergency expenses (46 percent) and day-to-day expenses (24 percent). Those are harder to avoid than a splurge, but there’s still plenty you can do to knock out your credit card debt. Here are my favorite strategies.
1. Balance transfer cards
My top tip is to sign up for a 0 percent balance transfer credit card. With some of these, it’s possible to pause the interest clock for up to 21 months. That could save you hundreds or thousands of dollars in interest.
Consider someone with $5,270 in credit card debt (the national average, according to TransUnion). If they only make minimum payments at the average credit card rate (18.16 percent), they’ll be in debt for 194 months (over 16 years) and will owe $6,601 in interest.
Those minimum payments start at $132 and decline along with the balance. That doesn’t sound like all that much on a monthly basis, but the minimum payment math is brutal over time. It includes more than a decade and a half in debt and a total interest expense that exceeds what you charged in the first place.
If you take advantage of a 21-month interest-free balance transfer offer, you could make 21 equal payments of approximately $251 and completely knock out your debt in less than two years without paying any interest. Note that most balance transfer cards charge an upfront transfer fee ranging from 3 to 5 percent, but that fee can be well worth it because of the long interest-free promotion.
You generally need a good to excellent credit score (at least a 670 FICO score) in order to qualify for the best balance transfer cards.
2. Personal loans
Consolidating your high-cost credit card debt into a personal loan is another potentially advantageous debt reduction strategy. If you have a strong credit score, you may be able to qualify for a personal loan with an interest rate of around 6 percent and a term lasting up to seven years.
However, the average personal loan rate is 10.73 percent and many people with lower credit scores are paying a lot more than that, so take a careful look at your specific terms before committing. Be aware of origination fees as well, which sometimes run as high as about eight percent of the amount borrowed.
3. Nonprofit credit counseling
A reputable nonprofit credit counseling agency such as Money Management International will work with you and your creditors to come up with a debt payoff plan. These often involve a four- or five-year term with an interest rate of around 6 percent. That’s similar to the personal loan parameters that someone with very good credit would receive, but when you work with a nonprofit credit counselor, you don’t necessarily need to have stellar credit.
Besides the mathematical advantages of a lower interest rate and a fixed term that’s much shorter than the minimum payment cycle, getting professional advice can be very valuable. Note that these plans often require you to close your credit cards, which may not be ideal, but it’s a tough love approach that benefits some people. MMI’s debt management plans charge an average monthly fee of $25 and an average one-time set-up fee of $33.
GreenPath is another of the largest reputable nonprofit credit counseling agencies. You can find more recommendations from the National Foundation for Credit Counseling. An important distinction to watch out for is the nonprofit designation.
For-profit debt relief companies often hurt your credit score by practicing sketchy tactics such as telling you to stop paying your bills for a while so they can use that as leverage to negotiate a settlement with the card issuer. This may not work, but even if it does, it will damage your credit score because late payments and settling for less than you owe are both frowned upon by the credit scoring algorithms.
4. Practice good fundamentals
In addition to the aforementioned strategies, I also think it’s important to look for ways to increase your income and cut your expenses. This might include taking on a side hustle, selling unneeded possessions, canceling little-used subscriptions, dining out less frequently and more. These changes don’t need to last forever, but they can make a big difference.
The bottom line
Credit card rates are often several multiples higher than other financial products such as mortgages, car loans and student loans. Of course, it’s important to keep up with those, too. But when it comes to paying more than the minimum, your credit card debt should probably be at the top of the list.
There’s a good chance your APR is 15 percent, 20 percent or maybe even more. It’s hard to decrease your balance — let alone build wealth — when your balance is accruing interest at such a high rate each month. But with a realistic plan in place and a commitment to stick to it, you can break the cycle.
Have a question about credit cards? E-mail me at email@example.com and I’d be happy to help.