Most people who struggle with debt have more than one creditor to deal with, and possessing 4, 5 or 6+ credit cards is not uncommon for the average household in the western world.

The main advantage of getting a debt consolidation loan to pay off all your personal credit cards debt, is that the Annual Percentage Rate (APR) of a typical consolidation loan will be lower than the APR of your credit cards. If you do the math, you’ll notice that this can save you quite a bit of money in the long run and allow you to pay off your debt faster than you would be able to do otherwise. On top of that, you’ll only have to pay one creditor, instead of needing to deal with several bills, different due dates, minimums and so on each month. If you’re able to get a fixed rate term loan, you’re also guaranteed that the interest rate won’t increase over time – something that credit card companies are not usually able to promise you.

On paper it seems like a great plan: cheaper, faster and convenient. There are however a few hitches to keep in mind before going ahead with this plan of (debt) attack. The first issue concerns the lending institution where you get such a loan from. If your credit is excellent and the amount of debt that you have is relatively small, you can probably obtain a simple personal loan, which won’t affect your credit score too much. In most cases though, if you are heavily in debt, chances are that your credit score is not that great to begin with. If you apply for personal loans which in turn get rejected, you credit will be affected negatively, making your financial situation slightly worse off than it already is.

You may be able to obtain a loan for the specific purpose of debt consolidation by talking directly to your credit union or banking institution, or by first seeking debt counseling with any one of the many non-profit companies who specialize in this field. There are two inconvenient aspects however, if you opt to go this route though. Firstly, in most cases you will have to provide a co-signer or some form of substantial collateral such a car, as well as a budget that’s outlined to the last penny and which shows that you are able to handle the monthly payments. Secondly, and perhaps more importantly, a debt consolidation loan is a glaring red flag in your credit history. Taking out such a loan is not a decision which you should rush into lightly, it truly affects your credit and is best viewed as being something of a “last resort” option.

Perhaps the biggest problem with debt consolidation loans has to do with the psychology of the debtor (the person who is carrying the debt load). While such is not always the case, some people who are in debt are there due to poor impulse control and spending habits. What do you think it’s going to happen when the credit cards are freed (thanks to the consolidation loan) once again? You guessed it, many people end up accumulating further debt, because they haven’t broken free from their addiction to buying on credit yet.

These are all important aspects to keep in mind before proceeding to apply for a loan. There are times where debt consolidation is the only solution, short of filing for bankruptcy. Only you know your own personal financial situation well enough to be able to judge if this is the case. In many situations however, applying the debt-avalanche method, sticking with the goal of paying off your balances, and the determination not to rebound into consumer debt is what it takes to become debt free.

Photo credit: Lotus Head.

In practice this means that if you’re in debt, you will need a solid plan and personal discipline to get out it. The first thing that you’ll need to do is to remove your reliance on credit. Stop adding more debt by ceasing to use your credit cards ¹. Secondly, determine the maximum amount of money that you are comfortable with and can afford to put towards your debt each and every month. This number should be greater than the sum of all the minimum payments.

The mathematics and psychology of debt repayment

Unfortunately, having figured out the monthly repayment that you can afford doesn’t tell you anything regarding how you should go about repaying your debt. If you only have one credit card or loan then the math is much easier. You just need to pay back the whole amount on that card, preferably through some form of monthly direct debit (from your bank account), so that it’s automatically taken care of for you.

Realistically though, most people who are in debt have an outstanding balance on several credit cards and possibly some loans ² as well. How should they distribute the repayment money each month? Should they divide the monthly amount by the number of cards and repay each of them equally? Should they pay proportionally based on the amount due on each card?

The goal here is to minimize the total amount of interest fees that you’ll have to pay your creditors over time, therefore allowing you to get out of debt as quickly as possible. The answer to this problem is mathematical, and it’s not a matter of opinion. There’s no room for “I think my method is faster…” type of thoughts. Basic mathematics already provides us with the best possible order of payment, so as to minimize interest.

That said, getting out of debt is a long process which generally involves a great deal of emotional involvement. The method for getting out of debt is only successful if you stick with it. For this reason, some people feel that a slightly suboptimal strategy, from a mathematical standpoint, is still acceptable if the psychology involved makes it easier for the debtor to feel motivated and keep at it until the debt is extinguished.

Hence, there are two methods which are often recommended by financial experts and debt counselors: debt-snowball and debt-avalanche. Both are straightforward and easy to understand.

The Debt-Snowball method

The idea behind snowballing debt is that you should pay only the minimums on all of your credit cards, except for the card with the smallest balance. This card should receive all the remaining funds available for repayment. For example, if the total amount required to pay the minimum on all the other credit cards is $500, and your allotted over all monthly repayment budget is $1,500, then you should put $1,000 towards the card with the smallest balance. If you happen to receive a bonus or extra money that you intend to put towards the debt, this too should go towards the smallest balance. When the amount available is more than enough to bring the balance to zero, then any leftover funds should be put towards the second smallest card (the one with the smallest balance amongst the remaining debt carrying cards).

This method has the advantage of motivating you because you’ll quickly see the smallest card’s debt vanish. The downside is that it’s not the most efficient method, and as such you could end up paying more interests and being in debt for longer than strictly necessary. A great proponent of this method is the popular radio host Dave Ramsey.

The Debt-Avalanche method

The debt avalanche method is a variant of the snowball one ³, where instead of ordering the debt repayment from the smallest to the largest balance, the order is defined from the highest interest rate to the lowest. This method is the fastest and most efficient strategy for paying off your debt. The downside in this case, is that if the balance on the card with the highest APR is large, you may be paying off your debt for a very long time before being able to say, “cool, one less card to worry about”. Mathematically speaking, this is the winning strategy, though you’ll need to employ personal discipline here, so as to not get discouraged.

Which one is right for you?

To show you the difference between the two systems, I’m going to use an entirely fictitious scenario. Imagine that you have the following credit cards (for sake of simplicity, say that they all have a fixed minimum of $10 or the specified percentage minimum below, whichever is greater):

The total amount of debt is $24,000. Assuming that you had a monthly repayment budget of $1,500, the debt-snowball method would take 19 months to pay off the debt and incur $3,243 in interest. The debt-avalanche approach would take 18 months and end up costing you $2,717 in interest fees.

Debt-avalanche is the best way to go about things, because it’s both cheaper and faster. Supporters of the other method will point out that debt-snowballing will clear the outstanding balance from the two smallest cards in August and October 2008, respectively. Going the debt-avalanche route causes you to wait until May 2009 to see your first card paid off in its entirety. Debt-avalanche is a smarter choice if you are patient enough to see it through to the end (it’s the approach that I personally use). If you are inpatient, remember that an “immediate gratification” attitude is a huge contributing factor to consumer debt in the first place. Generally speaking, the debt-avalanche method is financially unbeatable, while debt-snowballing is emotionally gratifying, but economically not the most efficient option.

If you’d like to see these methods applied to your own specific situation, you can use the calculator available here. Whichever you choose, you’ll get out of debt reasonably fast. Just stick with it, as I’m doing, and you’ll be able to enjoy a debt free existence.

Footnotes

[1] The idea is to stop your reliance on credit. It’s possible to use a credit card as a debit card, by paying the amount that you spend back right away, but it’s a very risky approach which may lead you to incur further debt. Experts suggest that you cut up or place your credit cards in the freezer, so as to not be able to use them while out shopping.

[2] Exclude mortgage loans from the snowballing method. Consider them a fixed expense, like monthly rent payments would be. Also keep in mind the difference between open end and closed end loans. Open (aka flexible) loans are ones that allow you to deposit over-payments, so as to be able to pay off the balance owing faster. This type of loan can be viewed as a low interest credit card in your strategy, given that you can pay back as much as you want (or more accurately, are able to).

[3] This is also known as Laddering, while debt snowballing is known as Reverse-Laddering.

Disclaimer: I’m not a financial adviser, just a guy who has read a lot on the topic and wanted to share his findings.

Struggling with debt

US households are struggling with debt. The total consumer debt reached a staggering $2.570 trillion in May 2008. This huge number is based purely on credit cards and other loans which aren’t backed up by real estate properties. As such, this figure doesn’t include the trillions of dollars of debt which is due to mortgage loans.

The average American already owns 4 credit cards, and to make matters worse — despite a sharp decline due to the subprime mortgage crisis — 1.132 billion credit card offers were mailed out in the first quarter of 2008 alone. These generated a response rate of 0.4%, therein creating millions of new credit card requests.

An excellent documentary on the subject of debt and predatory lending is Maxed Out: Hard Times, Easy Credit and the Era of Predatory Lenders (also available as an Amazon Unbox download, and in book form). It’s been a wake up call for many and is highly recommended.

There are many reasons why people get into debt and not all of them can be blamed solely on frivolous or unwise spending habits. The younger adult bracket is, for example, characterized by significant debt which was incurred due to student loans. With an exception made for higher income households, for almost 1 in 3 Americans, medical bills were a contributing factor to their current debt status. To top this off, salary increases have failed to counterbalance the negative effect of inflation and the basic cost of living. It’s worth pointing out that this is not a problem which is limited to Americans. Citizens from the UK, Canada, Australia and other countries in the Western world are facing similar difficulties.

Whatever the reason for their debt, chances are that many readers of this blog are facing these kinds of struggles, and it’s an undeniably tough situation to be in. When most of your paycheck goes towards paying rent (or mortgage payments) and consumer debt, your perception of stability and security starts to falter, and you truly feel vulnerable.

About half of all US consumers carry a balance over from month to month, while around 11% of them cover only the minimum monthly payment. Paying back debt that’s been incurred is painful when you’re already living paycheck to paycheck and having trouble meeting the cost of essential needs like housing, food, transportation and health care; but paying revolving credit card companies the minimum amount that they ask you each month, is a sure way of remaining in debt for decades — while earning them huge sums of money in interest. Let’s see how this works and why it’s a dangerous trap for consumers to fall into.

It’s a trap, and you’re the mouse

Many people wrongly assume that covering the minimum repayment on time each month is an affordable way to pay off their credit card debt. Simply stated, this couldn’t be further from the truth.

In general, the minimum payment due is a certain percentage of the current balance or a minimum amount (e.g. $10), whichever is greater. The percentage is credit card specific, but 3% or 5% are common numbers. Credit card companies like to have this percentage low, because it will take you longer to pay it off and in the process you’ll end up accumulating more interest for them, as long as you primarily make only the minimum payments due.

The monthly interest that the company charges you on the other hand, is obtained by dividing the APR (Annual Percentage Rate) by 12 to obtain the monthly interest rate, and then multiplying it by the balance you’re carrying.

Imagine that you have a 19.5% APR credit card with a balance of $4000 and 3% minimum payments (or $10, whichever is greater). If you were to only pay the monthly minimum, how long do you think it’ll take to pay off the amount owing in full and bring the balance back down to zero? It would take you 19 years. Or in other words, your last payment would be in 2027. Not only that, by you’d have paid back the initial $4000 plus more than $4500 in interest as well. And this doesn’t account for possible annual or late payment fees. As you can see, only paying your minimum payments is a trap that will keep you in debt for a ridiculously long amount of time.

Putting a fixed amount (that is greater than the minimum) each month towards that debt will extinguish it much sooner. The table below shows you the amount of time and interest spent, for several possible monthly amounts.

Keeping a relatively high balance/limit ratio for a long time will also negatively affect your credit. No matter what it takes, and we’ll discuss ways to handle this, it’s crucial to pay more than the minimum payment required.

Paying the minimum on some of your credit cards is OK if you have a plan, a mathematically sound system to get you out of the hole you’ve dug yourself into. Two different methods that are commonly used to tackle debt are debt snowballing and debt avalanching. In my next article on the subject, I’ll cover and compare the two.

Feel free to anonymously share your situation and plans, if you’re struggling with debt.