How to Pay Off Debt When You Are Broke
Broke people can pay off debt, it’s just a little trickier.
Don’t let high interest rate debt take over your budget.
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Sadly, Hanukkah and Christmas are over. While we’re still officially in the holiday season until New Year’s Day, you’ll notice the seasonal smiles will slowly start being replaced by somber faces. What has changed? I call it the annual Holiday Debt Hangover. Like all hangovers, this one starts long before you start feeling bad, and […]
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This means that when the Federal Reserve decides to raise interest rates, you can expect your rates to increase, too. There are rare fixed-rate credit cards, but they’re hard to come by and only available with excellent credit.
In 2017, the Fed already raised interest rates twice by 0.25% each time. Most credit card companies calculate APR as the prime rate plus a certain percentage. So, while the prime rate increased by 0.5% this year, your APR may increase more.
Credit card companies didn’t design the minimum payment system to be an effective way to get out of debt. In fact, interest charges are how issuers make profit, so they’d probably prefer it if you stay in debt forever. A standard minimum payment calculation takes a percentage of your current balance, such as 2.5%.
At such a low percentage, monthly interest charges eat up roughly 2/3 of every payment you make. Even with a low APR credit card with interest charges around 15%, it eats up half your monthly payment. As a result, you can pay month after month and not make an effective dent in your debt. You have to pay more than the minimum payment to eliminate credit card debt efficiently.
Creditors split card users into 3 different groups:
Issuers prefer people who are revolvers because they generate more revenue through interest charges. Transactors avoid interest charges entirely because they pay their balances in-full every month. If a cardholder starts a billing cycle with no balance and then pays off all charges within that billing cycle, no interest charges accrue.
A transactor’s pay-in-full strategy means they reap all the benefits credit cards without the extra cost of interest charges. It’s the best way to use credit as a consumer; even if it doesn’t make the credit card companies happy, it makes your wallet happy.
These days, many credit cards are fee-free. However, some new rewards credit cards have annual fees up to $450 or more per year. These credit cards usually offer the biggest rewards and best perks. However, it only makes sense to get a high fee card if the rewards are higher than the fee itself.
Basically, this means high fee credit really only provides a benefit to highly active transactor cardholders. Transactors earn all those great rewards and pay no interest because they always pay the bill in full. In this case, paying a high annual fee is reasonable to get so much back.
Earning 5% cash back is great, but even a relatively low APR of 15% offsets that cash back quickly. Let’s say you charge $1,000 and earn 5% cash back; that’s $50 you earn earned. At 15% APR, interest charges equal $12.50 of your $25 payment. If you don’t pay the debt off within the first 4 billing cycles, that $50 gets offset entirely by interest charges.
If you make a purchase that will take a few billing cycles to pay off, use a low APR card. You may want to earn the rewards, but it’s not worth it if you can’t eliminate the debt quickly.
If you miss a payment by more than 60 days – i.e. you don’t pay for 2 billing cycles – you incur penalty APR. This rate can be double or more what you pay normally. In fact, penalty APR can be so high that you get trapped in something called “negative amortization.”
Negative amortization happens when accrued monthly interest charges are higher than the minimum required payment. So, you make a payment on time, but your balance goes up instead of down.
You can restore the standard rate for purchases on a card by paying on time for 6 consecutive months.
Credit cards have a feature that allows you to withdraw money at an ATM. However, unlike your debit card that draws from an account, the funds come from your open credit line. This means you incur interest charges. Cash advance APR tends to be higher than standard APR for purchases. It’s usually over 20% APR and often over 25%.
What’s more, there is no billing cycle delay on interest charges. As soon as you make the cash advance, the creditor applies the cash advance APR. So, it always costs something to use this convenience. If possible, just use the credit card to make the purchase instead of withdrawing cash to cover it.
Often when you open a new account the creditor extends special interest rates on purchases and balance transfers. They may offer 0% APR on purchases and transfers for a few months – usually between 6 and 18 months. This is beneficial because it allows you to charge and pay off debt interest-free.
Just be aware that if you have a balance when that promotional period ends, you incur interest charges on the full balance. Ideally, you want to have zero balances when the promotion window closes.
This is especially true if you use a balance transfer credit card to consolidate debt. If you transfer balances from existing cards to a new card with 0% APR on balance transfers, you have time to pay off the debt without worrying about interest charges. But once the standard APR on balance transfers kicks in, you’re back to high interest charges.
If you’re considering balance transfer as a way to consolidate debt, check with your creditors first. Some credit card companies will happily accept transfers from accounts with other companies; however, they won’t transfer a balance from one of their own cards.
Chase® is one of the credit card companies that have this policy. If you have a Sapphire card, you won’t be able to transfer the balance to a Chase balance transfer card. Chase is not the only company that does this. Check with your creditors or review the balance transfer policy before you open one of these accounts.
If you have a major expense, such as a home renovation project, don’t use credit cards to fund it. High interest rates mean higher total cost for your project. A $10,000 project funded with credit at 15% APR results in $9,636.88 in total interest charges on minimum payments. Even if you make $250 fixed payments every month it equals out to $3,949.66 in total interest charges. Your $10,000 project costs almost $14,000 total.
Often a better solution is to take out a personal loan. Loans have lower interest rates than credit cards – usually less than 10%. You still increase your total cost with interest charges, but for much less. For example, let’s say you take out a personal loan for $10,000. With excellent credit, you can qualify for a 6% interest rate in today’s market. The monthly payments would be comparable at $234.55 per month. But the lower rate reduces total interest charges to $1,272.81. Always consider all financing options before you pull out the plastic on a big project.
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