by Dayana Yochim, The Motley Fool
Tuesday, December 1, 2009
Does this article’s headline sound like heresy? Does it smack of the worst financial advice of all time?
That’s exactly what credit card companies hope you think.
Consumers have been conditioned to pay attention to one thing when they open their credit card bills: the minimum payment due. But that minimum payment is just a smokescreen to distract you from the numbers that really matter — how much you owe overall, and the interest rate the bank is charging you.
Pay the minimum the bank requires to keep your account in good standing, and when you retire you’ll still be paying off that pizza you ordered during your freshman year. Simply doubling that minimum payment can significantly shorten the payoff time – not to mention the price tag of that pizza before it ends up costing you $1,000. Here, use this credit card calculator to see for yourself.
As long as I’m picking apart some old rules of thumb, let’s talk about another one that deals with which credit card you should pay off first.
Actually, Ignore the Interest Rate for a Moment, Too
If you carry debt on multiple credit cards, concentrate first on paying down the one that’s closest to being maxed out.
Why not pay off the one with the highest interest rate? Or maybe pick off the one with the lowest balance so you can start your debt-payoff plan with a win? Sure, financially and psychologically, both of those tactics make sense, but if you want to improve your credit score — and who doesn’t? — you first need to pay down the card that’s charged up the closest to your credit limit.
The credit world likes to constantly measure how you handle your debts. And when your debt-to-available-credit ratio starts creeping above 30% (e.g., carrying $3,000 in debt on a card with a $10,000 limit), red flags start waving and your credit score takes a hit. That single measurement counts for 30% of your overall score.
So job No. 1 is paying down any debt that’s bumping up against the limit. Once you get the ratio down to less than 30%, then start paying down the card that carries the highest interest rate.
Now, you might be wondering exactly where you’re supposed to get the money to pay down those maxed-out cards. Glad you asked.
Raid Your Savings Account and Put It to Better Use
Yup, you read that right. I’m not being flippant. I am fully aware that in these tough times, everyone should have a cash cushion for emergencies. But maybe your emergency fund doesn’t need to be quite as robust as you think it does.
An emergency may or may not happen. But credit card debt is very real, and very right now. If you have a fully funded emergency account, devote some of it (note that I said “some,” not “all”) to paying down your credit card balances. And if you have other cash “investments” sitting stagnant and earning just a pittance in interest, there’s definitely no better actual investment than paying down a credit card that’s costing you 14%-plus interest, as opposed to earning zero-point-something in interest.
Meanwhile, consider supplementing your emergency savings with an “emergency credit card” that has no balance and is set at a low interest rate. Then if an emergency does indeed occur (and we’re talking about a legitimate emergency, not a shoe-sale or waxing “emergency”), then you can cover it and not break the bank if you need a few months to pay off the balance. If an emergency doesn’t arise, well, then the cash you’ve put toward paying off your debt in the meantime is an even smarter investment for your future.
In person, Fool.com writer Dayana Yochim isn’t as preachy as she sounds in print. Except on the topic of credit card debt.
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