How to Pay Off Credit Card Debt for Good
Credit card debt is toxic. You can easily spend hundreds of dollars each month, barely making a dent in your loan balance.
But there is another way: once you pay off your credit cards, all of that money will be available for more important things. You’ll be able to plan and save for future goals, and you’ll feel less pressure each month when your bills are due.
The Road Ahead
If you’ve reached the point where you’re ready to pay off your credit card debt – but you’re not sure how to do it – it’s time to form a plan. This doesn’t have to be difficult. In fact, you’re more likely to succeed with a simple (but solid) strategy. We’ll focus on three key areas:
- A strategy to pay off your cards
- Ways to pay less interest while you reduce debt
- Mistakes to avoid
First things first: you'll need money to pay off your debt. Whether you earn more, spend less, or sell the things you don't really need, this is only possible if you've got at least a little bit extra cash on hand. Need some ideas on ways to save? Here are 25 of them.
You can certainly wing it if you like – it’s never a bad idea to throw extra money at your credit card bills. But with a bit of planning, you’ll increase your confidence and your chances of success.
The Right Strategy
To pay off debt, you’ll need to pay more than the minimum. But how exactly should you do that? Any payments above and beyond your required payment will help reduce the debt, and there are two popular strategies that others have used with success.
Debt snowball: the “debt snowball” is a way to build momentum as you reduce debt. Popularized by Dave Ramsey, the idea is to pay off your smallest debt first, then pay off your next smallest balance, and work your way up. For example, if you have two credit cards, one with a $400 balance and the other with a $2000 balance, you’d pay off the $400 card first. This method feels the best – you get to experience quick and increasingly significant victories on your journey to debt freedom. Studies in behavioral finance tell us that some people are more likely to stick to the program with this route.
Debt avalanche: another approach is the “financially optimal” approach. Instead of paying off your smallest balance first, you’d focus on paying off debt with the highest interest rate first. For example, if you have two credit cards, one charging 10% APR and the other charging 18% APR, you’d pay off the card that charges 18% as quickly as possible. Even if you could wipe out the 10% card quickly (and it’ll take you several years to pay off the 18% card), your goal is to pay as little interest as possible. You won’t experience the same psychological satisfaction as you would with the debt snowball, but it’ll cost less in the long run.
Which method should you use? The one that works – either is fine. The big-picture goal is to pay off your debts, and while it might make mathematical sense to use the debt avalanche, it doesn’t make any sense unless you actually pay off debt. If you get discouraged and lose motivation (or see that in your future), try the debt snowball.
If you really want to see how these two strategies compare, run the numbers yourself. It’s not terribly difficult to build a table showing how your credit card payments (and extra payments) work.
While You Wait
It will take time to pay off credit card debt – possibly several years. If you can transfer the debt to a lower-interest-rate loan, you’ll save money (and pay off your debt faster). The main reasons to stick with credit cards might be:
- If you’ve got a 0% APR credit card
- You’re going to use credit card balance transfers to take advantage of promotional low-rate offers (and you’re going to actively manage your debt)
Alternatives to Cards
If you’re paying too much on your credit card, there are plenty of alternatives. You might even decide to consolidate your debts (or combine all of your loans into one larger loan) – especially if you can get a better interest rate.
What types of loans can you use to consolidate credit card debt? It’s best to use unsecured personal loans: these are loans you qualify for based solely on your credit scores and income. You don’t have to pledge any collateral (which means you won’t lose anything of value if you can’t repay the loan – although your credit will suffer). Credit card debt is already unsecured debt, so you’d need a good reason to switch to a secured loan.
Peer to peer loans are loans that usually come from other individuals, although sometimes a bank funds the loan. Instead of borrowing from your local bank or credit union, you apply for a loan at a peer to peer lending website. People with extra money on hand can pitch in to fund your loan, and you’ll often pay lower interest rates than you’d pay to traditional lenders or credit card issuers.
Online marketplace lenders are the next generation of peer to peer lenders. Again, you’re mostly borrowing from non-bank lenders: investors (whether they’re institutions, banks, or other organizations) with extra money decide whether or not to fund your loan, usually based on your credit score and income. If you have bad credit or you’ve never built up your credit, these lenders might look at “alternative” sources of information to decide whether or not to approve your loan.
Banks and credit unions are also worth a look. They can usually offer unsecured personal loans with rates that are much lower than credit card interest rates. Credit unions are sometimes less expensive than banks (and more willing to approve loans), so be sure to check a few credit unions as you shop around.
If you consolidate debt, you’ll want to be aware of two potential problems.
No refills: after you pay off a credit card with a consolidation loan, it’s tempting to use that card again and rack up debt. Don’t do it. Remember that you haven’t actually paid off any debt yet – you’ve only shifted your debt elsewhere.
Higher payments: if you use a consolidation loan, you might have higher monthly payments than all of your credit card “minimum” payments combined. That’s because you’re actually paying off your debt – and you’ll often do it within three to five years. Make sure you know what you’re getting into before you agree to anything. Use a loan amortization calculator to see how your payments look (using a personal loan instead of a credit card) over a three year period.
What to Avoid
You’ve already got expensive credit card debt, but things can still get worse. It’s tempting to go for a quick fix, and some of these fixes are “so crazy it just might work.” But if you’re going to use the strategies below, be aware that you might be making an expensive mistake that can haunt you for a lifetime.
Where is your largest source of funds? For many, it’s in a retirement account like a 401(k) or IRA. You’ve spent years building up those savings, and you won’t need them anytime soon, so why not use them to pay off credit card debt?
The problem is that you’ll have to start from scratch when it comes to saving for retirement. You’re older now than you were when you started saving for retirement. To get back to where you are, you’ll have to make significant contributions to your retirement accounts – possibly unaffordable amounts (similar to your credit card payments). You’ll have one problem solved, but you’ll create a different one – and there won’t be any quick fixes available later.
You might see this as your only alternative to defaulting on your loans or bankruptcy, but you need to speak to a local attorney and financial planner before you tap retirement funds. In some cases, your retirement savings are protected from creditors – unless you voluntarily pull the funds out. Wouldn’t it be nice to at least have some assets to your name, even if you have to declare bankruptcy?
Pledging (Important) Collateral
If you’ve got low credit scores or insufficient income to qualify for a loan, you might be tempted to borrow against your assets. Unfortunately, you’d create a risk where you didn’t previously have one: if you stop making credit card payments, your credit scores will drop, but nobody can come and repossess your car or force you out of your home.
If you get a home equity loan, you’ll have access to a lot of money at a low interest rate. However, those loans are secured by a lien on your house. If you fail to pay the loan, lenders can foreclose on the home and sell it to get their money back.
The same is true for car title loans: you can get cash quickly, but you need to make all of your payments on time. If you don’t our vehicle can be repossessed, and you’ll have a hard time getting to work and earning an income. That will only make it harder to pay off debts.