As new provisions from the 2009 Credit Card Accountability, Responsibility and Disclosure Act take effect today, Americans are continuing to struggle with burdensome credit card debt. The number one question readers ask me is how to deal with credit card debt -- and the volume of e-mails on that topic has only grown during this recession. As you know, I've turned this column over to the cause of showing people how to "SAVE BIG." That's the title and topic of my new book, but more importantly it's my passion…maybe even my obsession. I'm happy to report that just as it's possible to buy and maintain a home or a car for less, it's possible to pay off a credit card for less. There are better, smarter and faster ways to pay off credit card debt that can help you SAVE BIG.
Pay in the Right Order
People always ask me, should I pay down the highest interest rate first or the highest balance first? That's a great question because you can, indeed, retire your debt faster by paying down your credit cards in the most beneficial order. The way to SAVE BIG is to move from highest to lowest interest rate. Why? Simply because the debt with the highest interest rate is costing you the most money. The less time you are carrying a balance on that card, the less time you will be paying that onerous interest rate. When that balance is wiped out, move on to the next highest.
Many respected experts argue that people should pay off the cards with the smallest balances first, for the psychological boost of finishing off an entire debt and moving on to the next. I think that's insulting. If you are reading this column you are a savvy consumer and you don't need artificial pick-me-ups that cost you money. Let's do the math. Let's say you have a $5,000 credit card debt at 29.99 percent and a $2,500 one at 9.99 percent. Here's how much it costs you in interest to pay them off if you make the typical minimum payment of $300 on the two cards plus add an additional $50 per month.
Benefit of Paying the Highest Interest Card First
Interest owed by paying lowest balance first = $2,641
Interest owed by paying highest interest first = $2,332
SAVINGS = $309
Why would you want to waste $300? I stand by my strategy. Fire on the highest interest debts first. If you would like to experiment with different payment strategies, check out this excellent calculator from Bankrate.com.
Pay More Often
Now, here's a more unique strategy you may not have heard of. Instead of paying your credit card bill once a month, when it's due, try making a half payment every two weeks. Many of us are paid bi-weekly, so this evens out your cash flow. More importantly, it results in making more payments per year, since there are more than four weeks in most months. You've probably heard of this technique for paying mortgages off early. Well, it works for credit cards too. The reason is basic: there are two months of the year that you end up making three payments instead of two.
I'm going to use a real whopper of a debt for this example, to show what a difference this strategy can make. Let's say you owe $20,000 at 24.99 percent interest. A typical minimum payment would be $800 a month. So instead you send $400 every two weeks. Here's how this will help you SAVE BIG:
Benefit of Paying Bi-Weekly Instead of Monthly
Schedule interest owed monthly: $8,539
Schedule interest owed bi-weekly: $7,539
SAVINGS = $1,000
It's amazing! Not only do you save $1,000 in interest, you cut four months off of your repayment schedule by paying bi-weekly! The upshot of paying bi-weekly is that you end up sending in just $67 a month extra. Of course, I don't encourage anybody to make just the minimum payment. This strategy works even better if you pay more. The best plan of all is to keep making the same size payment even as the minimum payment required goes down.
Now, here's the exciting part. There's another factor at work here that I haven't even included in the math because, frankly, I'm not sure how to do the calculation. By making one of your payments earlier in the billing cycle, you are short-circuiting some of the credit card company's interest charges. How? Because credit card companies charge interest every day of the billing cycle. By paying some principal early in the cycle, you are reducing the average daily balance that interest is based on!
Using the 14 day payment method is easy with online, automated banking. Just make sure your bank won't fine you for not paying the entire minimum balance on the due date, since that's what banks are used to. Some people send small amounts even more often. If you do that, check to see if your bank limits the number of payments you can make per month. The excellent Web site CreditCards.com keeps track of these rules in its section on "micropayments." Click here to read the rules.
Use Savings to Pay Debt
And now a fast-lane strategy for paying off credit card debt that some will find obvious and others will find sacrilegious. I know lots of smart people who have a good-sized savings account and credit card debt. That is just dumb. Oh, did I say that out loud? I know, I know, people feel it's important to save for emergencies. Trust me, credit card debt is an emergency. It is sapping your financial strength. You can instantly make a "profit" by using low-interest savings to pay off high interest credit card debt.
If your savings account yields 2 percent interest and your credit card charges 17 percent interest, you make a 15 percent "profit" by using the savings to pay off the debt. Money managers would kill to make that kind of gain in the stock market! Here's how the numbers would play out with a balance of $10,000.
Using Savings to Pay $10,000 Debt
Rate ............................... Interest
Credit card debt @17 percent: $1,700 charged
Savings account @ 2 percent: $200 earned
SAVINGS = $1,500
If these numbers didn't convince you and you are clinging to the idea that you need a large savings account in case of an emergency, then think of it this way: take the sure savings and gamble on the possible costs. You are guaranteed to save money by using your savings to pay your debt. You may or may not have a future emergency. If you do, you can use your credit card to pay for it. Still squeamish? Let's compromise. Keep $1,000 in your savings account. Send the rest to your credit card company and start to SAVE BIG.
To be clear, I am not talking about tapping into a 401k or IRA here. If you already have money in one of these retirement accounts, don't withdraw it because the penalties could well be worse than the credit card interest. If you are contributing to one of those while you have credit card debt, stop and pay the debt first. The one exception is if your employer makes a match, in which case you should contribute just the amount that is matched to get the free money.