Understanding debt: Two strategies for eliminating credit card debt

Overview
In last week’s article, I described the trap set by credit card issuers to create a great source of long term income by keeping card users in debt for many years. This type of debt is designed to entice card users to only pay a very low monthly payment for easy access to borrowed funds. If the card user only pays the low minimum monthly payment, they could end up paying more than 25 years on the associated debt before paying off the card. That assumes no further debt is added onto the card balance. Each month most of the payment is interest income to the card issuer and very little goes toward reducing the debt. That is the trap set by card issuers. This article will describe two strategies for reducing and eliminating this debt. Before presenting the strategies, we need to revisit last week’s description on what credit card debt really costs.

Disclaimer
Throughout this article, I quote numbers that come from a crude credit card payment calculator I created using Microsoft Excel. The numbers may not be exactly accurate, but they are close enough to illustrate my points being made.

Revisiting last week’s discussion on the long term cost of a credit card purchase
I showed how a $2,000 TV purchased on credit could cost you a total of $8,183.46 by paying only the minimum payment for 26 years, giving the card issuer $6,183.46 in interest. That also assumes you don’t make any more purchases on your credit card to add to the debt, and it assumes the interest rate stays at 19.99% over the 26 years. I also showed how a fixed payment loan for the same interest rate and $2,000 in debt only costs the borrower $2,636.54 in interest over a 10 year loan. Both forms of loans start with about the same monthly payment of $40. The main difference between the two is the credit card monthly payment goes down each month since it is tied to a percent of the remaining balance while the fixed payment loan always stays the same each month. Therefore, the credit card debt is interest focused while the fixed payment loan is debt reduction focused. Over time, more of the fixed payment goes to paying off debt while the credit card monthly payment is designed to always continue paying the least amount toward reducing the debt. One thing credit card users may not be aware of is that they can turn a credit card debt into a fixed payment debt.

One debt reduction strategy: Make a credit card debt act like a fixed payment loan
One debt reduction strategy I like to teach is to continue making the same payment each month on your credit cards (assuming no new debts have been added onto the card). Don’t pay the decreasing minimum monthly payment each month. Instead, continue paying the same amount you paid last month. What this does is turn your debt into a fixed payment loan. As you continue making the same payment, more and more of the monthly payment will go toward paying off debt and less toward interest. Assuming the interest rate on your card does not change, then your credit card debt would be paid around the same time as an equivalent fixed payment loan, 10 years in the case of the examples provided in last week’s article. You will then be rid of all your credit card debts if this strategy is used on each one with no additional debts added on.

Another debt reduction strategy: A small incremental increase in monthly payments dramatically reduces debt
Another twist on the previous strategy is to increase your monthly payments by an additional $5 each month over what you paid the previous month. This means skipping one meal out per month to get the additional $5. If your payment is $40 this month, next month make a $45 payment. The month after that, make a $50 payment. After continuing this for a year, your payment would grow to $100 each month which is the consistent $40 monthly payment plus an additional $60 (12 months x $5 extra each month or $60). Consider that all of this additional $60 is going toward paying down the debt and none of it toward interest since interest is covered within the consistent $40 portion of the payment.

This debt reduction strategy dramatically accelerates payoff of the balance and also dramatically reduces the amount of total interest being sent to the credit card company. If this strategy were used for the same $2,000 credit card debt, the total loan would be paid off in only 26 months (2 years and 2 months) with only a total of $584.41 being paid in interest and total payments totaling $2,584.41 for the $2,000 TV (see last week’s article). This compares to total payments of $8,183.46 when paying only minimum credit card payments for 26 years or total payments of $4,636.54 for a 10 year fixed loan. You can see the dramatic difference a small incremental amount each month can make for the total cost of the TV and the time to pay off the associated debt.

Next week’s continuation
In next week's article, I will show how to combine both strategies to accelerate paying all your credit cards off. I’ll also show how to move beyond paying off your credit cards to paying off all your debts using these strategies and one more strategy. Come back next week.

Copyright 2008 Ole Cram, President of Marcobe Investments, Inc.
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This article was posted at Accredited Investor Blog: http://accreditedinvestortalk.blogspot.com/. Key past articles related to investments in oil and gas can be found at http://www.MarcobeInvestmentsInc.com/Oil_and_Gas_Investor_TOC.html. This article is provided for educational purposes only and is not meant to be a substitute for tax, legal, financial, or other registered professional advice for your specific situation. Always seek the advice of a professional before making any related decision. Sphere: Related Content