Put Your Debts on a Totem Pole
The following is an excerpt from You're So Money: Live Rich Even When You're Not, a practical personal-finance guide by Farnoosh Torabi, a senior correspondent for TheStreet.com. The book is aimed at young adults who want to live beyond their means, but spend within them. This excerpt explores the best strategies to pay down your debt and get rid of your credit-card woes.
Dealing with debt starts with figuring out where each outstanding loan sits on the debt totem pole.
Think h-i-e-r-a-r-c-h-y.
Traditionally, the loans you should deal with first, the ones up top, have the highest interest rates and aren't secured. (Any debtlike credit-card debt, store credit, etc., is not secured because there's no asset to back up the money owed. The opposite would be a mortgage, which is secured because if you default on your mortgage, the bank can take your house.)
Toward the bottom of the totem pole sits the low-interest-rate debt and debt that is secured, such as your car loan, your home mortgage and student loans. These loans offer relatively more flexibility.
Top of the Totem Pole: Plastics
On average, the U.S. consumer, according to some recent stats from
, carries more than $9,900 in credit-card debt. While that's less money than the average student loan, credit-card debt is by far more expensive to carry than a Perkins or Stafford loan because of the higher interest rates.
The average annual percentage rate, or APR, for a standard credit card is around 13%, compared with 7% or 8% on a student loan. The cards with the highest rates should be your first concern because they're your most expensive loans. Like student loans, it may be worthwhile to consolidate your credit-card debt.
In some cases you may find it helpful to transfer your balance on one card to another charging less interest. We'll explore these options here. And remember
options
is the key word. You have choices, and more than a few. It takes some moxie and logic to erase debt. And it goes without saying: To pay off the credit cards, you gotta stop using them.
Step 1: Ease the Interest
Gather up your credit cards and rank them by interest rate, highest to lowest. If you have just one card and have good credit, call up the credit-card company and ask for a lower rate. Throw into the conversation that you're considering transferring your balance to a different card company offering a lower rate. That usually does the trick. If you have
more
than one card, you will either want to consolidate or tackle each one separately.
Step 2: Size Up Your Cards
For those with numerous credit cards (i.e., two-plus), there are a few ways to manage the debt.
Let's picture this scenario with three credit cards and the following debt loads:
- $4,000 on credit-card No. 1 (leftover from college, APR 22%)
- $550 on department store card (last week's shopping binge, APR 18%)
- $1,000 on credit-card No. 2 (spring break 2007, APR 15%)
Cramer: Farnoosh's Immigrant Parents are So Money |
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Step 3: Choose a Payoff Plan
Get High
: One route to paying off credit-card debt is first paying off the card with the
highest
interest rate, or credit card No. 1 in our above scenario. The logic: This is your most expensive account.
With a 22% APR, the longer you wait to pay it off, the more money it will cost you. This 22% APR card in our imaginary scenario also happens to have the highest balance. If it had the
smallest
balance, I'd still recommend paying it off first.
(Note: If your credit score is shot -- as in below 600 -- this may not be the most recommended payoff method, especially if you need to buy a car or take on a bank loan of some sort.
Why?
Because for low credit-score bearers, it's paramount you reduce your debt-to-available-credit ratio as fast as possible, since you've the highest risk of getting refused for a car loan or student loan. Attack the debt that will be easiest to pay off first, doing whatever will quickly get you on track and in the habit of paying off all your debt. You may want to begin by paying off the card with the smallest balance, which I explain below, and working your way up.)
Start Small
: Some may want to get rid of that $550 store credit-card debt before any other because it's the least daunting and offers a psychological boost. Attempting to erase $550 vs. $4,000 of debt is a less discouraging way to get into payoff mode. From there, you could tackle the remaining two credit cards, again, either by the size of the debt or by APR.
Go to the Edge
: If you're really close to maxing out one of your cards, pay off that one first. Reason is, you get penalized for getting too close to the limit on any credit card. Your interest rate might go up on that card and consequently other cards. Your credit score will also take a hit because, again, it's all about that debt-to-available-credit ratio. If you're using 90% of a credit card's limit, that's way too high. I've heard you don't want to use up more than 30% of a card's limit to avoid losing points on your credit score. So if that $1,000 balance is sitting on a card with a $1,500 max, you may want to start there first.
Farnoosh Torabi joined TheStreet.com TV in July 2006 as the site's first official video correspondent. Previously, Farnoosh was a business producer and on-air reporter for NY1 News, Time Warner's 24-hour news channel in New York City. Farnoosh is a regular columnist for AM New York and has written for Money, Time, New York Daily News and Newsday. Farnoosh is a graduate of Pennsylvania State University, with a degree in Finance and International Business and holds a M.A. from the Columbia School of Journalism.