I don’t write much about debt, but handling debt is probably one of the most important parts to personal finance.  The reason I don’t write about debt very much is because I’ve been lucky enough to only have “good” debt, e.g., student loans and mortgage, both of which are at low fixed rates.  I’m one of the lucky few.  Many, if not most Americans struggle with debt.  The other day I was talking with my friend, Mary Ann, about her credit card debt, trying to give her some advice on how to tackle it.  It’s easy to say pay if off, but it’s harder to come up with a concrete plan.  Given that the interest rate on her credit card is at 20%, finding creative ways to pay off that debt quickly can make a huge difference even in a few months.

Before I start examining specific strategies, I also believe it’s critical to make that debt tangible in some way.  I believe many individuals get into credit card trouble because debt itself is an ephemeral beast. Debt has no physical body.  Debt makes no sound but still manages to keep some people up at night.  Trent at The Simple Dollar suggests creating a visual reminder of debt such as progress bar.  This is a fantastic idea, as it serves to remind us of our obligations, and serves as positive reinforcement of good behavior.  I didn’t really start making true progress with my own finances until I started tracking my monthly net worth.  A simple visual reminder can be simply writing down how much debt you have at the beginning and at the end of each month on a 12 month calendar.

Mary Ann doesn’t have an enormous amount of credit card debt, only $5,220. However, even that small amount at 20% interest means she’s paying about $87 in interest a month!

My first suggestion is to apply for a 0% balance transfer. The only caveat is that many of these credit cards require a good-to-excellent credit score. The process of applying for a credit card involves a “hard credit pull” which actually inflicts damage on the credit score.  Also, Mary Ann informed me that she had a little over $700 in unpaid parking tickets that she only recently paid off.  These tickets may be a problem as they are most likely have adversely affected her credit score.  Also, if she can she’s better off applying for credit cards she’s been solicited or offered.  If there aren’t any attractive offers being made to Mary Ann currently, the following are all very attractive balance transfer credit cards with great promotional rates.

I would also consult creditcards.com for a more comprehensive list of balance transfer offers. Even a credit card that has a balance transfer fee which typically run 3% of the balance transferred are a good deal given that Mary Ann’s paying over 3% every two months.

One of the real benefits of transferring credit card debt to another credit card via a balance transfer offer is that it’s absolutely free of most complications.  The minimum monthly payment should not go up, nor are there penalty rates once you go beyond the promotional period.  Yes, 18% is a penalty rate, but doing nothing at 20% is already a penalty.  Things can only get better except the credit score.

Even if your credit is good enough to qualify, often times the credit card companies do not give you enough credit to transfer the entire balance. Applying for multiple credit cards will hurt the credit score more, but if you’re not applying for a mortgage right now, taking a temporary hit to your credit score is OK. That said, credit scores affect many other things, too, such as insurance premiums.

If the balance transfer route doesn’t work out, there are still alternatives.

  • Call your credit card company and try to negotiate a lower rate
  • Apply for a loan on prosper.com, and get other people to bid on your loan. I would actually do this first, as you can set up a loan listing with very low interest rate (less than 6%) to get a vague idea of what your credit score is.  Once you know in what vague range your credit score you can better apply for the right credit card.  The alternative to getting graded on prosper.com is to get report from service such as www.freecreditreport.com. However those free credit scores online have many catches, and I generally advise against using them as they try to trap you into a credit monitoring service.

Prosper.com

I’m actually a lender on prosper.com, which, for people who haven’t heard of it, is a peer-to-peer lending website. Basically, I and other individuals collectively lend money to others who have made loan requests on the website. While I’m personally ambivalent about how well prosper.com works for lenders, I do think it can be a good opportunity for borrowers without other recourse to pay off high interest credit card debt. Not knowing exactly what Mary Ann’s credit score is, I’m not sure what kind of rate you can get on prosper.com. If I had to venture to guess, it would be in the 11%-17% range. These are not great rates, but it’s still better than 20%.

Currently, Mary Ann pays between $200-250 to her credit card each month. She’s been good and hasn’t been adding to the debt, but she does occasionally make a few transactions. I’m going to assume that $220 a month goes to servicing debt, i.e. paying interest ($87 a month) and paying down principal. Assuming that Mary Ann continues to apply the same amount to her payments, ideally, by doing a balance transfer or a combination of a balance transfer and a prosper loan, she can take some serious steps towards paying down her debt. After a year she can reduce her total balance owed by as much as $850 (using 0% balance transfer) without changing her monthly payments.

Once Mary Ann has figured out how much of her credit card debt she can transfer to a 0% APR offer or prosper.com, we should look at the bigger picture of both how much more she should be directing towards paying down her debt, and how she can do it if she can. Compared to many other Americans, she’s in pretty good shape.  Her fixed costs, rent and utilities, is on the low side, averaging about $650 a month or so. She has no other debt other than credit card, though beginning next year she will have about $27,000 in graduate school loans to repay.  Tomorrow we will look at next steps.