When we charge stuff, we're borrowing money at a very high price, usually 13%- to more than 20% percent, and buying something that immediately starts depreciating in value, like shoes, clothes, electronics or a vacation. If we can't pay the balance off each month, it ends up costing a lot, sometimes almost three times as much as the price paid. So it doesn't really matter whether it was 60% off and a “great deal.”
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According to The Federal Reserve Bank of New York, Americans in Q4 2014 had an average of $2,710 worth of credit card debt. The worst kind of credit card debt is when paying only the minimum amount each month.
"At that point, you're making a lot of money for the bank," according to Lou Body, a financial planner at Crimson Financial Strategies, which is based in Jacksonville, Florida.
The good news is, there are some easy things we can do to make it cheaper and shape up our credit profile, which is what a bank will look at before giving a loan for a house, car or for starting a small business.
PAY OFF MOST EXPENSIVE CARD FIRST
First, arrange your credit cards by the highest cost, or annual percentage rate (APR) to the lowest and pay off the highest one first.
This sounds like a no brainer, but most of us don't pay attention to the rates charged by each card, according to Carl A. Friedrich, managing director of FCE Group, an investment advisory firm based in New York.
"Everyone knows paying off a card with a 9% APR before one with an 18% interest rate doesn't make sense," Friedrich said. "But people don't invest the time to think it through."
In fact, depending on your budget, it may be better to make just the minimum payment on the lesser expensive cards, in order to pay down the one with the highest interest rate, according to Body.
Another way to tackle credit card debt, is to transfer your balance to a card with a lower interest rate. Most cards will charge about 4% for the transfer, which is less expensive than, say, 17% over the year.
Transferring can be a good idea, as long as you can pay it off at the lower rate (sometimes 0%) or transfer again, before it jumps up. But as for your credit score, transferring has pros and cons. It can be positive, because you're getting rid of one balance, but negative because you're opening new lines of credit to do so.
If you'll need a good credit score soon, it's best not to transfer too many balances, according to Friedrich.
HOME EQUITY LOAN
Another strategy for paying off balances is to borrow money at a lower rate to pay them off. Homeowners can usually get a home equity line of credit at a better rate (about 4-1/2%) and use that to pay off card balances. But there are closing costs, plus the risk that the home may lose value over time.
BORROW FROM YOUR 401K
Perhaps the best option for eliminating credit card debt is borrowing money from a 401K retirement plan. In this case, you can borrow 50% of the value of your plan (up to $50,000). You would pay it back through payroll deduction, within a specific timeframe, including interest payments to yourself.
This is a good idea because there's no transfer fee or closing costs and the interest (usually around 6%) is paid to yourself. But the negative is that you can lose out on investment income from the amount you borrowed, or you may have to liquidate stocks and bonds to do so. Also, if you lose your job, you would have to pay back the loan, or you'd owe income taxes and an early withdrawal fee of 10%.
Using credit cards and paying the balance off every month is fine, because you're not allowing the bank to charge you interest and it actually helps establish your credit score. But making minimum payments and ignoring the rates can be very costly. So take control of that bad debt and at least make it better, by winding down the most expensive balance first, then work on the others.
It could be motivating to get a free copy of your credit report at an authorized online source, such as www.annualcreditreport.com.