The Cure for the Financial Hangover
December 28, 2011Now that the holidays are behind us, do you find yourself carrying a few extra financial “pounds?” That is, did you put so much of your holiday shopping on plastic that you end up starting the New Year carrying a balance on your credit card? If so, then you’re probably not alone. According to First Data, credit card use among holiday shoppers soared, and continued use could make the problem worse. The good news is that there is a cure to the financial hangover. It begins with a commitment to get rid of the debt, followed by a plan for reducing it. To help you get started, here are some simple steps you can take to start shedding the financial weight:
Step 1: Make a spending plan that includes making extra payments on credit cards
As part of your New Year’s resolutions, add the creation or refinement of a spending plan (i.e. budget). Start by making a list of all your regular monthly expenses, and add line items for non-monthly expenses (e.g. insurance, car repairs, holiday shopping), saving for goals, and extra debt payments.
The more you can make in the form of an extra debt payment, the faster you will pay it off, so if you find that you are not using your gym membership after a few months, consider cancelling it and putting that money toward the debt-reduction goal.
Make sure you have at least $1,000 in an emergency fund before you begin making extra payments on your credit cards. Otherwise, an unforeseen expense could undo months of progress.
Step 2: Reduce the cost of your credit cards
When you carry a balance on your credit cards, you may begin to notice an increase in the frequency of balance transfer offers. It may be tempting to take advantage of the first 0% interest offer that comes in the mail, but there are some important things to consider before you do.
The Good
The primary benefit of a balance transfer is the opportunity to refinance your credit card debt at a lower interest rate. This will not only reduce the amount of interest you pay, but can accelerate how quickly your debt is totally paid off. Another advantage is consolidation of debt, especially when you carry balances on multiple cards.
The Bad
Many balance transfers come with a one-time transfer fee, typically 3% of the amount transferred. Also, the low interest rate may be for a limited time, or you lose the promotional rate if you fail to make payments on time, so what might look like a “lower” interest rate could eventually become a higher one down the road.
The Ugly
The worst thing that could happen is for a credit card user to transfer a balance from one card to another, only to spend up on the first card again.
A balance transfer is a good option when it is part of an overall debt-reduction strategy. If you decide to take advantage of such an offer, make sure you understand ALL the costs involved, that you are in a financial position to make payments on time, and that you eliminate the temptation to use the old credit card again.
Step 3: Employ a repayment strategy
There are three strategies for making extra payments: highest interest rate, lowest balance, and pro-rata.
When using the highest interest rate strategy, you simply make minimum payments on all of your credit cards except the one with the highest interest rate. Channel all extra payments to the one card with the highest rate until it is completely paid off. You then roll that payment into the card with the next highest rate until it is paid off, and so on and so on. This will provide the fastest payoff with the most money saved of the three strategies.
The lowest balance strategy is very similar to the highest interest rate strategy, except all extra payments are made on the card with the lowest balance. Since the lowest balance does not always have the highest interest rate, it may not pay off the debt as quickly, but paying off a card in full gives the borrower an emotional lift, and may be the motivation they need to keep making extra payments.
The pro-rata strategy simply spreads the extra payments across all outstanding balances in proportion to the size of the balance. This will accelerate the payoff of all your credit card accounts, though not necessarily as quickly as the highest interest rate method.
Regardless of which strategy you use, the key is to make extra payments. If you can’t squeeze an extra payment out of your budget, maybe you can reduce the cost of debt through a balance transfer. The sooner you understand the relationship between these three steps, the sooner you are to waking up to a debt-free morning!