Steps to Paying Off Credit Card Debt

One of the biggest challenges for new investors might have to overcome when they first decide to start building wealth is a mountain of credit card debt. They find themselves paying hundreds of dollars each month in interest and this can prevent them from paying down the principal. But tens of millions of Americans live free from the burden of credit card debt with a few common-sense tactics.

Stop the Blame Game

Many people can benefit from learning to accept responsibility for their financial lives. It’s easy to blame the economy, the political system, or your boss, but there's nothing you can do to fix the situation if you don't accept any personal responsibility for your dilemma.

You have one lump sum of money available to you. Take every extra penny you can get your hands on and get rid of the debt if you're paying massive interest on your balances.

Think Twice About a HELOC

Many financial planners will tell you to use a home equity line of credit (HELOC) to pay down high-interest credit card debt, but your credit card balances are unsecured while a home equity line of credit is secured by your house.

The worst a credit card company can do is take you to court and get a judgment against you if you don't pay, but he bank can foreclose on your home and put you and your family out in the cold if you don't pay on a HELOC.

A home equity line of credit might make sense if your credit card debt is manageable and you just want to save a few thousand dollars in interest expense. But it can cost you your house if you think there’s even the slightest possibility that you may won't be able to make payments at some point in the future.

Take Out a 401(k) Loan

It's almost always a better choice to lower your debt levels than to contribute toward retirement if the interest rate you're paying on debt exceeds 10% to 12%.

Consider taking a loan from your 401(k) if you have one. The interest you pay on this type of loan goes back into your account, so you're effectively paying interest to yourself. You can avoid taxes and the 10% early withdrawal tax penalty as long as you repay the loan within five years.

Now, the downside: You must pay off the loan before the beginning of the next tax year if you lose or leave your job unless you can transfer it to another 401(k).

Take Back Roth IRA Contributions

IRS rules allow you to withdrawal Roth Roth IRA contributions you’ve made tax-free, although you can't withdraw gains earned on the money tax-free and there's generally a 10% penalty if you do so before age 59½.

For example, you can take back up to $20,000 without any tax penalties or consequences if you’ve deposited $20,000 into a Roth IRA over the past 10 years and have made $10,000 in profit. Of course, you'll lose the chance to grow your money outside of the reach of Uncle Sam, but that might be far better than drowning in high-interest credit card debt.

You can take earnings penalty-free if you're at least age 59½, but you'll still have to pay taxes on these withdrawals.

Brokerage and Other Investment Accounts

Investments you hold in regular brokerage accounts, such as stocks and bonds, will be subject to capital gains tax when you sell unless you lose money in the transaction.

Short-term tax rates apply if you've held the assets for one year or less, and these rates are the same as your ordinary income tax rate. Otherwise, gains are subject to a preferable long-term rate—0%, 15% or 20%, depending on your overall income—if you've held ownership for more than a year. Most individuals pay 15% according to the income parameters, according to the IRS.

The emotional release that comes as you pay off a big chunk of your credit card debt might nonetheless be less painful than a tax cut taken by the IRS.

The Snowball Method

You can remove an entire fixed payment, instantly making your existing money stretch further, by paying off your credit card with the lowest balance account first. This approach is referred to as the "snowball method" because the amount of money you direct to each payment gradually snowballs as that debt is reduced. Eventually, you'll be remitting large amounts to attack your biggest—and last—debt.

Take the money you were paying on the lowest credit card balance after you've paid it off and send that money to the next lowest. Repeat this process until you're left with your single, biggest debt.

This cycle repeats until you've paid off all your credit cards. The downside here is that it's not a quick, easy fix.

Make Micro Payments

snowflake technique paying off credit card debt
The snowflake technique is designed to help you pay off credit card debt by sending in so-called micro-payments. These payments can literally be a few dollars and, over time, add up to big balance reductions, saving you thousands in interest expense. Getty Images

The snowflake technique is an alternative to the snowball technique. Every time you get more than a few dollars in your hand, send it to your credit card company to reduce your balance. It doesn't matter if you make a payment for $7.12, $14.35, or $3.54. It works out to $1,000 a year taken off your credit card debt even if all you can find is an extra $2.74 a day to pay on your cards.

It's easy to ignore the power of small amounts. These little sums might not look like they're even denting your credit card debt, but the results will be nothing short of spectacular in the aggregate and over the years.

Cut Up Your Credit Cards

frozen credit card debt
One technique for reducing credit card debt suggested by financial planners is to freeze your cards in blocks of ice, helping you avoid the temptation of non-essential purchases. Getty Images

A financial planner once told clients to freeze their credit cards in blocks of ice. They would be forced to melt the ice whenever they were tempted to spend, giving them time to rethink impulse purchases.

An even better solution might be to cut up your cards entirely so that you can’t charge anything else. Personal finance expert Dave Ramsey calls cutting up your cards up a "plasectomy."

Take on Additional Work

Consider taking on a weekend job on top of your day job and save every penny after taxes. Dedicate that money to paying down the balances on your accounts.

You'll accelerate your debt payoff as you pay less interest on your outstanding balances. Your monthly income will go up even without that additional work when you've finished paying off your debt because you've freed up money that you had to spend on debt servicing before.

Negotiate With Lenders

Credit card companies know that you can discharge your debt through bankruptcy, so it's sometimes possible to get them to lower your interest rate—even significantly—by simply telling them that you see no alternative but to declare bankruptcy unless they modify the existing terms.

You might have to spend a good deal of time on the phone, escalating from supervisor to supervisor, but ultimately you have a good chance of going from a 30% credit card interest rate to something in the neighborhood of 13%.

The Nuclear Option—Bankruptcy

The “big red button” is bankruptcy in the world of personal finance. It's possible to completely eliminate credit card debt with a Chapter 7 bankruptcy filing, or at the very least have a court-ordered restructuring under a Chapter 13 bankruptcy. This will give you some breathing room with lowered payments while you can get your life back in order.

The downside to this option is that your credit will be ruined for up to 10 years, although much of the damage fades after seven years.

Chapter 7 Bankruptcy

Chapter 7 bankruptcy allows you to start over, almost like hitting “reset” on a video game. Your debts will be effectively erased—poof! They're gone when they're discharged.

The downside is that the bankruptcy trustee effectively takes ownership of all your assets when you file for Chapter 7 relief, subsequently selling them and paying any proceeds to your creditors. The bankruptcy code does provide for exemptions, however—values in certain items of property, such as your home, that can't be sold.

Chapter 13 Bankruptcy

Another drawback is that the bankruptcy rules can force a lot of middle-class workers to file for Chapter 13 bankruptcy instead. You'll have to agree to pay back your debt from future earnings, entering into a court-supervised repayment plan that lasts three to five years.

Seek out a qualified bankruptcy attorney in your area if you want to start over and are willing to go through the process of bankruptcy. They can explain the drawbacks, costs, benefits, and process to you. In some cases, it might be better to clean the slate and start over to begin rebuilding your financial life.

Your creditors can't harass you or take any collection action against you during this time, and not all of them will receive all you owe. Unsecured claims such as credit card debt generally aren't paid in full. These creditors must only receive at least as much as they would have if you had filed for Chapter 7 protection instead and if the trustee had sold your non-exempt assets.

Article Sources

  1. IRS. "Retirement Plans FAQs Regarding Loans." Accessed March 11, 2020.

  2. Debt.org. "401(k) Loans: Should You Borrow From Retirement?" Accessed March 10, 2020.

  3. Charles Schwab. "Roth IRA Withdrawal Rules." Accessed March 10, 2020.

  4. IRS. "Topic No. 409 Capital Gains and Losses." Accessed March 10, 2020.

  5. Debt.org. "Debt Snowball Method Works – But It Will Cost You $$$$." Accessed March 10, 2020.

  6. United States Courts. "Chapter 7 - Bankruptcy Basics." Accessed March 10, 2020.

  7. United States Courts. "Chapter 13 - Bankruptcy Basics." Accessed March 10, 2020.