Debt Reduction

Dealing With Debt

Credit cards and other forms of debt can be an essential part of your financial toolbox, but you must exercise care when using these tools. Understanding the difference between good debt and bad debt will go a long way in making sure you create and maintain a good credit history.

Beware of the Warning Signs of Too Much Debt

How to Tell if You’re in Over Your Head

Do you have debt that is bogging you down and keeping you from reaching your financial goals? Using credit and debt can be a powerful tool that allows you to buy a home, a vehicle, send children to college, and even provide leverage for other purchases, but when you accumulate too much debt, it can pose a serious problem.

Keeping up with your debt payments is only part of the problem. Just because you can afford to fit these payments into your budget, you’re still putting added strain on your finances. Money that is used towards paying down debt can’t be used elsewhere. That means if you’re spending money each month on credit card or other unnecessary debt, you’re taking money away from other areas of your budget that can be used to build wealth and plan for the future.

It can be difficult to actually realize when you’ve reached a critical point with your debt situation, but there are some warning signs that can help you identify the problem before it becomes too serious to address. Here are a series of statements to compare to your situation. If any of these apply to you, it is time to stop and take action to remedy the problem.

Take Action Now

Sometimes we know deep down inside that we have a debt problem, but it is easier to deny the problem than to address it. It can be painful and require hard work, but the sooner you realize that you are in over your head, you can begin to make positive changes. Delaying changes to your habits will only prolong the problem and make it worse. If you don’t think you can tackle the problem alone, there are people out there willing to help.

What You Need To Know Before You Can Get Out of Debt

To get out of debt, you need to:

  1. Assess your financial situation
  2. Understand the basics of how credit works
  3. Get help when you need it
  4. Budget and cut costs
  5. Avoid credit and debt mistakes

Breaking the Minimum Payment Habit on Your Credit Card

Paying More Than the Minimum Saves You Money

One of the most costly mistakes you can make with credit cards is getting into the habit of only paying the minimum amount due each month. While the minimum amount may be affordable; it will also cost you more money in the long run.

How the Minimum Payment is Calculated

To better understand why paying the minimum can be so costly it is important to learn how the minimum payment is calculated. While each card can use a different calculation they all use a certain percentage of the balance as a primary factor. This could be as low as the finance charges for that period plus 1% or upwards of 4-5% of the balance. Make sure you check your credit cards to determine how the payment is calculated.

Example

For an example let’s take a look at a credit card with a balance of $1,000 that has an APR of 18%. When you break the APR down to twelve monthly periods you end up with a 1.5% finance charge per month. For this example we will also use the assumption that the card calculates the minimum payment by 2.5% of the balance.

This means your minimum payment in the first month is $25, or $1,000 x 2.5%. With the card’s APR of 18% or 1.5% per month that means of that $25 payment only $10 is being applied to the balance while the other $15 is paying that month’s finance charge. During the next month your remaining balance is now $990 so your next minimum payment would be calculated as $24.75 ($990 x 2.5%). For this payment $14.85 covers that month’s finance charge while $9.90 is applied to the balance.

As you can see above, you have made almost $50 in payments yet only reduced your balance by $19.90. If you were to continue paying only the minimum and the features of this card remained unchanged it would take 153 months or almost 13 years to pay off a $1,000 initial balance. This would result in paying $1,115.41 on just interest alone, more than the amount of the original balance!

Putting the Plan Into Action

It is easy to get into the habit of making only the minimum payments. They are low and it can free up cash flow for other areas of your finances. Unfortunately, paying the minimum can be very costly as demonstrated above. Even a very low balance can cost you more in interest and take over a decade to repay. Compound this problem with multiple credit cards and higher balances and you can see why it can be so difficult to get out of debt.

To combat this problem, you need to find a way to pay more than the minimum each time, even if it is only a little bit extra. If the minimum payment is $40 then make an effort to send at least $50. You probably won’t notice the extra ten dollars but it will go directly onto your principal and eat away at the debt even faster.

As you can afford to do so, you should increase this extra payment. Try increasing it $10 each month until you are beginning to really put a dent in the balance. Doing this will literally shave years off the repayment period and save hundreds or even thousands of dollars.