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Understanding your credit cards and managing debt
How to manage credit cards and credit card debt
We now live in a plastic society, and no, I’m not talking about those people who have nipped, tucked, and injected every inch of their body with Botox. It is a rare thing to find someone these days who carries around cash, pays their bills with an old fashioned paper check, and considers a tucked away envelope of cash as their savings account. In today’s world it is simply easier and more convenient to swipe and go as you purchase, bundle, and spend your way into a bottomless pit of debt. In 2013, according to creditcards.com, the Survey of Consumer Finances found that the average credit card debt for a household that carries a balance was $5,700. It also found that 38% of all households carried a balance on their credit cards.
However, using credit cards does not mean the end of the world. It is possible to use these accounts to your advantage. The key to using a credit card responsibly is this; never purchase something that you won’t be able to pay off at the end of the month, rely on for emergencies only, and if it is a big-ticket item consider other forms of payment such as a low interest loan. If you can’t afford to take out a low interest loan, or don’t have the required credit score, then you probably shouldn’t be purchasing that item anyway.
Plastic Spending Power
Choosing a card, responsible usage, and the high price of interest
Before you sign on the dotted line for your new credit card you should consider several factors. To begin with, what are you spending habits? Are you the type of person that spends impulsively? Do you plan to carry a balance, use it for everyday items, or do you plan to only use it in emergencies? If you chose to carry a balance it’s important to know that any balance remaining on your card at the end of the month is subject to accrue interest.
There are many ways to use a credit card, but some are certainly better than others. If you want to avoid building up a crippling debt then you should follow some simple responsibility rules when it comes to wielding your plastic spending power. To start with, avoid getting cards that have a higher credit limit than you could reasonably pay back. This is also a safety concern because if someone were to get a hold of your credit card and make fraudulent purchases, you don’t want to wind up owing thousands more than you could feasibly pay off.
Another good rule to follow is paying off your balance to zero each month. Of course, you can squeak by only paying the minimum amount (I’ll address why that’s a bad idea later on), but that debt will still be there. The longer it sits the higher it will become. If you’re an impulsive spender then keeping a ledger of what you spend daily is a good way to keep yourself accountable and insure that you don’t end up in the red.
However, one of the perks of a credit card is that you can enjoy a product without having the money up front. So, if you know you’re going to carry a balance (say you’ve earmarked the credit card for a special purchase such as an engagement ring) than you want to pay close attention to the interest rate. However, if you are going to be paying it off each month than the interest rate is of little importance.
Some people get credit cards purely to build up their credit. This can be a good choice, if you know you can pay the bill off at the end of each month. Ideally, you won’t use the credit card with the intention of carrying a balance because you’re going to wind up paying more to buy things after you add in the borrowing interest.
One perk of having a credit card is that the credit card company typically offers an incentive to get the card. For instance, Capitol One’s quicksilver card offers 1.5% cash back on all spending and a $100 bonus if you spend more than $500 in the first 3 months. Each credit card has its own set of rewards and drawbacks, so it’s important to research which one is the best fit for your lifestyle.
So, if you plan on getting a credit card solely for gas purchases in order to build up your credit, choosing a card with a great rewards program may outweigh having a low interest rate. This can be a great plan, but then you need to be sure that you can pay it off each month.
If you have poor credit, don’t want to be tempted to spend more than you have, or simply want the convenience of a credit card without the risk of being charged interest, then a debit card may be a good alternative. A debit card is linked to your bank account and draws money directly from your account rather than a creditor. The downside to having a debit card is that you run the risk of accidentally overdrawing your account and being slapped with penalties and fees. However, many banks now offer overdraft protection by linking your savings account to your debit account. If you accidentally overspend then it will automatically pull the money from your savings and save you an overdraft charge.
The truth behind minimum balance payments
One of the scariest words to hear these days is “interest”. Everyone knows that having a high interest rate is not a good situation. Though sometimes it can be unavoidable, such as student loans, one should always try their best to avoid accruing interest. That’s just common knowledge. However, credit card companies want you to accrue interest, again, common knowledge.
What they have done is create a clever way to make more money off of their borrowers by setting a minimum payment amount. This is not something that they are required to offer customers. They do so because a minimum payment amount serves as an anchor.
See, if you borrow $400 from a credit company and pay it back in full at the end of the month without having to pay any interest then they don’t make any money. So, the credit card company sends you your monthly statement that says Joe Schmo owes $400 but can make a minimum payment of $20 with no late fee. Joe Schmo thinks, “Great, now I have an extra $380 to spend elsewhere this month” and now his remaining balance of $380 gains interest. On his next statement he owes $385 but again, he only has to pay $20. Over time Joe Schmo ends up paying a lot more than the $400 he originally borrowed and that extra money is pure profit for the credit card company.
Now, in the previous example the anchoring number is $20. The $20 is irrelevant to the actual $400 that Joe owes. This is just a number that the credit card company made up to bias Joe’s judgment when he goes to pay them back. Instead of paying as much as he could afford to pay, he now pays a lesser amount back than he would if the $20 anchor weren’t there.
In “The Cost of Anchoring on Minimum Credit Card Payments” we can see just how much paying minimum payments can cost us in the long run. In this study participants in the United Kingdom were randomly assigned to non-anchored and anchored groups. All groups received mock credit-card statements with the same balance and they were asked to consider how much they could afford to pay, and then how much they would pay. The statements between groups were identical in every way except that the anchor group saw included a minimum payment.
What they found was that the portion making full payments was not significantly affected by the anchor. Those with a minimum payment paid along the same distribution curve that was seen in the real world. However, for those making partial payments that did not have a minimum payment amount, the mean repayment amount rose by 70%. That means that when a minimum payment is not present, we’re inclined to repay more than if it were present.
It’s not surprising then that the credit card companies want to include a minimum payment on their statements. Counteract this anchoring effect by making your budget BEFORE you open your statement. If the amount you can afford to pay is significantly higher than the minimum payment, then pay the higher amount. You’ll save money by doing this and avoiding rising interest.
Effects of Anchoring with Minimum Payments
Repayment - no minimum present
Repayment - minimum present
Repayment - in full
40% of balance ($175)
23% of balance ($99)
No significant Change ($435.76)
The Average American has 3.7 credit cards
How many credit cards do you carry a balance on?
What to do if you’re over your head
Before you begin chipping away at your credit card debt, first write down your monthly budget. If you find this particularly difficult to do, then start a daily spending diary. This consists of writing down each day what income you received and what amount of money you spent. At the end of the month compile your list into categories and transcribe that into a monthly budget. Having a hard copy of your budget is imperative when facing your debt.
The second thing you need to do is determine how much outstanding debt you have floating out there. Dave Ramsey, author and budgeting expert, has many budget forms, program information, and additional literature that you can access for free online. His program is simple and easy to follow, though if I am being honest I tweak his program to fit my personal lifestyle.
Essentially what he recommends is this, cut your budget down to the bare bones and reduce frivolous spending. Instead, throw your money at your debts, starting with the smallest debt first. He recommends doing this and ignoring the interest rates as you’re more likely to stick with the plan if you have successes. The easiest success is to pay off the smallest debt first and work your way to the larger one.
This is not a bad plan; however, this is not how I am going about paying off my own debts. My fiancé and I have a car payment that is our 2nd highest debt and we plan on paying off this debt first. Why? Because once we pay off the car loan our insurance rate will drop significantly and we will no longer be required to carry full coverage insurance. So, evaluate your own bills and do what makes the best sense for you. However, if you have a plethora of debts floating around, then it may be worthwhile to simply start at the smallest and snowball your way up as Dave suggests.
Another step to take when dealing with you debt is to contact your creditors. Sure, it’s easier to duck the phone calls and pretend they don’t exist, but it is so much better for you in the long run if you face it head on. Ask if they are able to lower the monthly payment to something that you can afford. Usually they are more than willing to work with you because getting paid something is better than nothing.
If you’re really struggling contact a company or organization that offers debt consolidation and financial counseling, but remember that a legitimate organization with NEVER ask for you to pay them, and certainly not BEFORE you’ve successfully eliminated your debt. If it sounds too good to be true, it probably is. Avoid getting scammed and thoroughly research any company or organization that you are considering working with.
Then there is the b-word…that’s right I’m talking about bankruptcy. This is one of the most extreme measures to eliminate. There are basically two types of bankruptcy, Chapter 7 and Chapter 13. Both types will potentially eliminate your debts but they do so in different ways. Chapter 7 pays your debts by liquidating your assets to pay as much of the money owed as possible, but there are certain exceptions to this liquidation such as a primary residence. Chapter 13 requires the debtor to have a job or source of income and make payments over 3 to 5 years. Each type has advantages and disadvantages and you should seriously do your homework before declaring bankruptcy as it’s virtually credit score suicide. Always consult legal council before declaring bankruptcy and consider alternative methods to reducing/eliminating your debt.