Snowballing, HELs, cashing out, and chipping in. Here are nine strategies for paying off high-interest credit card debt.By David Braze You can throw the reminders in the Cuisinart or chuck them into a garbage can, but that won’t make the debt go away. Debt hovers like a carrion bird over a dying beast, costing you more than 18% compounded monthly, month in and month out. You can’t wish it away. But you can pay it down with determination, our free How To Get Out of Debt online guide, and the good graces of a few wealthy relatives (see tip No. 5). Here are nine ways to get out of debt:
1. Pay more than the minimum
First, break the habit of only paying the minimum required each month. Paying the minimum — usually 2% to 3% of the outstanding balance — only prolongs the agony. Besides, it’s precisely what the banks want you to do. The longer you take to repay the charges, the more interest they make, and the less cash you have in your pocket. Don’t play their selfish game.
Instead, bite the bullet and pay as much as you can each month. If your minimum payment is $100, double that to $200 or more. Examine your normal expenses — you can find the money. (For a gazillion ideas, check out our Living Below Your Means discussion board.) Skip eating out at lunch, and bring it from home instead. Eliminate desserts. Give up happy hour. We all have “luxuries,” and you know what yours are.
Make a few sacrifices, and you will find the extra dollars needed to increase your debt repayments dramatically. Those increased payments will save you hundreds, if not thousands, in interest payments. Plus, you will get out of the hole you’ve dug for yourself much more quickly. Is it fun? No. But it sure beats living a hand-to-mouth existence, fearing bills each month.
2. Snowball your debt payments
Take a long, hard look at all your credit cards. Pay particular attention to the one with the lowest interest rate. Have you reached the maximum limit on that card? If not, consider transferring a higher interest bill to that one. Many credit cards permit this, and it’s positively Foolish to trade an 18% debt for one at 12% at any time.
If your entire balance is too large to fit on one low-interest rate card, pay at least the minimum amounts due on all of your cards except one. Funnel the majority of your debt repayments into that one credit card, and pay it off as quickly as possible. When the balance on that card reaches zero, move on to the next with the same aggressive repayment plan.
Lather, rinse, and repeat. This method of snowballing your payments is aptly called “snowballing.” As your debts decrease, the amount of money you have to attack them increases. Your payments snowball until all of your debt is pummeled. Pretty neat, eh?
Another way to transfer higher interest debt to a lower-interest card is to take advantage of the promotional offers many banks use to entice you to their line of credit. You’ve seen the come-ons. “Transfer all your credit card balances to us, and pay just 5.9% until January 1, 2003.” It could be worth it. Moving to 5.9% from 18% interest could mean substantial dollars to you. And the money saved in interest could then be applied toward the principal each month, thus reducing your outstanding debt balance even further. (For more on how to take advantage of balance-transfer offers, head to step 2 of our free How To Get Out of Debt online guide.)
Take care, though, before you act. Examine the offer closely. Look for the hooks. Will the interest rate after the introductory period be higher than you’re paying now? If so, you may have to switch again at that time. That, in turn, could give rise to another surprise. Banks have caught on to the charge card hoppers who switch from card to card to take advantage of the low introductory rates. Many of these offers now stipulate that if you transfer balances from the new card within a 12-month period, the normal interest rate will be applied to all outstanding balances retroactively. That proviso could be a bitter pill to swallow for someone short on cash, and it certainly doesn’t help the debt repayment schedule. Read the fine print, Fool.
3. Cash out your savings account
You could cash out your savings and investments and use the proceeds toward debt repayment. Yeah, no one wants to do that. But sometimes it’s just Foolish to do so. Even when debt interest is at 12%, your investments would have to pay more than 18% before federal and state taxes to equal that outflow of dollars. We doubt the dollars in your savings account are earning anywhere near that rate of interest. Pay off the debt, and it’s the same as getting that 18% return without any risk on your part. The higher the interest rate on your debt, the more attractive repayment versus investment becomes.
4. Borrow against your life insurance
Do you have life insurance with a cash value? If so, borrow against the policy. Yes, you’re borrowing your own money. But the interest rate is typically well below commercial rates, and you can take your time repaying the loan. Do repay it, though. If you die before it’s repaid, the outstanding balance plus interest will be deducted from the face value of the policy payable to the beneficiary. As a negative, that seems a small price to pay to get out of debt now, but it could be burdensome to your family or loved ones should you sleep the eternal sleep before paying it back.
5. Finagle family and friends
Perhaps your family or friends could help through a loan. Who else knows, trusts, and loves you like they do? Unless you’re really the black sheep of the flock, chances are you’ll get a very favorable interest rate. They may even tolerate a late payment or two. But if you want to maintain the relationship, it’s best to keep things on the straight and narrow by using a written agreement. You should clearly establish the interest and repayment schedule in writing to avoid misunderstandings and hard feelings. And it goes without saying that you must be scrupulous about adhering to that schedule. Otherwise, you can forget the family reunions and birthday presents.
6. Get a home equity loan
Do you own your own home and have some equity that’s accumulated through the years as you’ve paid off the mortgage? If so, now’s the time to consider a home equity loan (HEL) line of credit for the maximum amount possible.
An HEL gives you a double whammy. First, you use the loan proceeds to pay down your debt, thus trading something like an 18% loan for a 9% loan. Second, most homeowners itemize on their income tax returns. HEL interest under most circumstances is a deductible item. In a 28% marginal tax bracket, the 9% loan really has an effective rate of 6.5%, and that’s probably the cheapest interest rate you’ll see on personal indebtedness.
The danger here is falling into a common trap. Many get an HEL, pay off existing debt, and then ring up the charges on the credit cards all over again. Now they have the HEL to repay on top of the credit cards. The hole just got much deeper. Fools use the HEL to pay off the credit cards, and then keep them paid off until the HEL is repaid.
7. Borrow from your 401(k)
Do you participate in a 401(k) qualified retirement plan at work? Most 401(k) plans have a loan feature that lets you borrow up to 50% of the account’s value, or $50,000, whichever is smaller. Interest rates are usually a point or two above prime, which makes them cheaper than that found on credit cards. Thus, 401(k) plan loans may be a Foolish option to debt repayment. Not only is the interest typically much lower than that on credit cards, the best part is you pay it to yourself. That’s right, every dime in interest paid on a 401(k) loan goes directly into the borrower’s 401(k) account, not the lender’s. That lessens the bite even more.
But there are some drawbacks. First, the loan and interest will be repaid with after-tax dollars, but the interest will be taxed again when you finally withdraw money from the 401(k) years later. Additionally, you must repay this loan in five years or less. If you leave your employment prior to full repayment, the outstanding balance becomes due and payable immediately. If it’s not repaid, that amount will be treated as a distribution to you. You’ll be taxed on that amount at ordinary rates. And if you’re under the age of 59 1/2, you will also be assessed an additional 10% excise tax as a penalty for an early withdrawal of retirement funds. Accordingly, ensure any 401(k) loan can be repaid before you leave your job.
8. Renegotiate terms with your creditors
OK, you’ve done all you can. Savings are gone; relatives have been tapped out; you don’t have a home or 401(k) to borrow against. You feel like you’re against that proverbial wall. The money just isn’t there. Is bankruptcy the only way out? No way. Try pulling that ace out of your sleeve prior to taking that step. What ace? The threat of bankruptcy ace, of course.
Let your creditors know your situation. Tell them that if you are unable to renegotiate terms, then you have no other recourse except to declare bankruptcy. Ask for a new and lower repayment schedule; request a lower interest rate; and appeal to their desire to receive payment. Faced with the prospect that you may resort to such a drastic step, creditors will do what they can to protect themselves against a total loss.
Indeed, many will negotiate away the farm before they’ll be willing to write off your debt. As lawyers love to say, everything is negotiable. Therefore, what do you have to lose, save time? It’s worth a try. And if you don’t wish to do this yourself, organizations exist that can do it for you. For details, see Step 5 (Debt Triage) in our How To Get Out of Debt Guide.
9. As a last resort, file bankruptcy
What if you decide you can’t pay down your debt using any of the methods listed above? What should you do? The absolute last resort is bankruptcy. Within Fooldom, we firmly believe everyone has a moral obligation to repay their debts to the utmost of their ability. There are times, though, when repayment may be impossible. In those cases, bankruptcy may be the only available course of action. Nevertheless, be aware of the significant drawbacks.
Your credit record will contain this information for 10 years, thus ensuring you will have a tough time obtaining credit you can afford during that period. Additionally, as odd as it seems, it also costs money to file for bankruptcy. Attorney and court filing fees cost in the hundreds of dollars, and they must be paid to obtain the relief sought.
There are two types of personal bankruptcy relief: Chapter 7 and Chapter 13. Chapter 7 is straight bankruptcy that allows the discharge of almost all debts. Those that aren’t discharged are alimony, child support, taxes, loans obtained through filing false financial statements, loans not listed in the bankruptcy petition, legal judgments against the petitioner, and student loans. While Chapter 7 relieves you of the responsibility of repaying most creditors, you may also have to surrender much of the property you own to help satisfy the debt. In general, though, you may usually retain your car, tools of your trade, your home, and most personal property.
Chapter 13, sometimes called the “wage-earner plan,” is different. You keep your property but surrender control of your finances to the bankruptcy court. The court approves a repayment plan based on your financial resources that provides for repayment of all or part of your debt over a three-to-five-year period. During that time, your creditors may not harass you for repayment. You also incur no interest charges on the indebtedness during the repayment period. When all conditions of the court-approved plan have been fulfilled, you emerge debt-free from the bankruptcy.