By: Frank Armstrong, CFP, AIFA
Many people use credit cards responsibly. They buy no more than they can afford and pay off the entire balance each month. Properly used they are a major convenience. Who in their right mind wants to haul around piles of cash just to buy milk at the grocery store?
Then there are credit card junkies. They finance their lifestyle on easy credit while sinking any chance to develop a net worth. Their debt and service costs just grow and grow as they indulge themselves while making or occasionally missing the minimum monthly payment schedule. You know which one you are.
Giving up your credit card habit may be tougher than quitting smoking, but it’s just as important to your financial health as cleaning up your lungs is to your physical well being.
It is easy to think that you should start to save and invest while carrying a credit card debt. But, credit card debt (and other consumer debt) is ugly through and through. You can’t swim or even tread water carrying that kind of load. You have a better chance of swimming a mile while carrying 20 lbs. of lead weights. Your first step toward financial independence is to eliminate all consumer debt and keep free of it. Your goal is to zero out the balance each month. Failing that, cut the cards up into little tiny pieces, pay them off, and don’t use them again – ever!
Total credit card costs include a confusing variety of fees and interest at rates that vary at the whim of the card company. Few cardholders understand the total impact of these charges against their outstanding balances. A cynical person might think that the disclosures credit card companies must provide are deliberately misleading, confusing, opaque and evasive. But, the total charges can vary from 18 to more than 30 percent. That’s significantly higher than any reasonable investment return we could assume.
Let’s consider the case of a couple with $10,000 in long term investments and a $10,000 credit card debt. So, looking at just those two accounts we have a net worth of Zero.
If you put a gun to my head, the most liberal guesstimate I could make on the long term prospects of an equity investment account would be 11%. But, there is a good argument that going forward returns might be closer to 8%. So, under our most optimistic assumption, that account might earn $1100 in an average year. But, the credit card debt is costing somewhere between $1800 and $3000+. Our net worth is going backwards!
By now, you should have rightly observed that liquidating the savings account to pay off the credit card debt is the rational way to go. By extension then, paying off any outstanding credit card debt should be a priority before beginning an investment program.
If you can’t pay off the credit card debt today, but you haven’t already totally destroyed your credit rating, you may be able to transfer it to a credit card offering short term “teaser” rates. Like a good drug pusher, they are anxious to get you hooked on their stuff, so they are offering “free” or almost free introductory rates. This may give you a chance to play them off against each other while you dig yourself out of debt.
Pay off the highest cost cards first, and roll that debt down to lower cost cards as possible. Keep at it until you are debt free.
If you are in over your head, you may be able to negotiate with the card companies for some relief. Somewhere there may be a legitimate credit counseling service, but so many of them are outright scams that it’s hard to recommend that approach. Far too many folks ended up with no relief and another pile of bills after succumbing to the lure of credit repair schemes. When you see those ads on TV loud little bells and bright flashing lights ought to be going off inside your head. Don’t go there.
As a last resort, you might consider a second mortgage. But, don’t go down that road unless it’s the last time you do. Systematically destroying your home equity to feed your credit card addiction is a road to ruin.
Refinancing gives you an opportunity to make the situation even worse by accepting one of the subprime mortgage products with teaser rates, variable interest charges sure to escalate, and 100% equity to debt ratios. Those toxic financial products have devastated thousands of families. It might appear to be a lifeline, but more likely it’s a mine that can blow up on contact. If you must re-finance, stick to traditional fixed rate mortgage products.
Once you have cleaned up your credit card debts, you can begin to build a financial future of saving and investment on a sound foundation.