Photo by Joshua Earle on Unsplash
Easy money is easier than ever before. This partly explains why consumer debt rose to $4.16 trillion in September 2020. Not the highest it’s ever been, but not far from it.
Plenty of types of consumer debts are reasonable, and even a good idea in many cases. But high-cost debts are the real killer.
In this article, I outline a six step process for killing high-cost debt. If you’re sick of carrying this financial weight around your neck, I think this will be helpful.
What is high-cost debt?
High-cost debt can be an unclear term, but most people know it when they see it.
Credit cards, with typical interest rates in excess of 15%, are without question high cost debt. Not only that, but there are no tax deductions or credits to help soften the blow, as with mortgage interest or student loan debt. (Side note: OK, I know you get credit card points, but 2% cash back or free flying miles for 20% interest on your balance isn’t exactly a winning strategy).
Some define high-cost debt as anything that exceeds what you could otherwise earn by investing in stocks. They reason that the stock market over the long term earns about 8% per year, so anything above that is high cost, while anything below that is not.
I don’t love this approach, as it assumes the investor puts all their investable assets into stocks, which is risky in its own right. In this regard, student loan debt with an interest rate in excess of 6% or so I would consider too expensive.
For purposes of this article, I’ll focus my comments on the ultimate high cost financial killer: credit cards.
Step 1: Admit there’s a problem
No, I didn’t say admit that YOU have a problem. This article isn’t meant to lay on the guilt in an effort to stimulate change. But the facts are clear: Carrying high-cost debt for long periods of time causes mental strain on individuals and families, and financial strain on achieving other meaningful goals, like retirement.
There’s another more subtle deceit with high-cost debt: It’s easy to ignore. Think about it. All the credit card company really asks is that you pay a very modest monthly payment. That payment is just another line item that comes out of your checking account, along with dozens of others each month. And you only notice this if you regularly check your transactions, like when updating your budget, which few people do. You receive an email notification that your monthly statement is available, a statement which does in fact show the grim details of what your debt is doing to your finances, but you need to login to your account to see these details, and let’s be honest, no one really looks at that.
Step 2: Figure out what you owe
So Step 1 is done and you’ve accepted the reality of the problem. f you don’t clearly know each of your credit card balances, interest rates, and minimum and monthly payments, start there. This may be one of the hardest parts of this whole exercise. You’ll be facing the music which may make you squirm, but it’s the right and best first step. Once you know them, write down all the details.
Step 3: Find your excess
Now that you have your debt in one picture, it’s time to start in on a plan to pay it off.
To do this you need to know your income, spending, and if there’s any excess. You probably know your income each month. Use your net amount--the amount that comes into your checking account after taxes and benefits.
Next, using bank and credit card statements, record all your transactions for the past two completed months. Two months is important to help identify any one-time expenses that aren’t typical month to month.
Notice that you aren’t creating a budget. We’re doing this exercise to find any excess. Budgeting isn’t necessary unless there’s no excess (more on that below).
Once you have the two months expenses compiled you can average the two amounts to reach your spending number. Subtract this from your monthly income. If there’s money left over, great. Going forward, these funds can be earmarked for paying off your high-cost debt, even if it’s just $100 per month.
If there’s nothing left or the amount is negative, then do the same exercise for three months and see if there’s a different outcome. If you are still falling short each month, then it’s time to create a budget and find areas to cut your spending.
Step 4: Cut wasteful spending with a budget
It doesn’t matter if you use a budget tool like Mint.com or YNAB, a spreadsheet, or a pad of paper and pencil. What does matter is that you review your spending habits (previous step) and use a budget to help yourself trim the fat if your cashflow is negative.
If you’ve never budgeted before, don’t expect to love it. You’ll be forcing yourself to create some spending constraints that you haven’t had to worry about. But if you can stick to the process and be disciplined, you’re on your way to killing your debt.
To help you get started finding areas to cut, try separating your expenses into essentials and non-essentials. Essentials are the bills you can’t escape, like your mortgage, utilities, and insurance payments. Non-essentials give you more wiggle room to cut. These are things like shopping, dining out, and vacations. There is some gray area here. For example, everyone needs to eat, so your monthly grocery bill may be listed as “essential,” but that doesn't mean you can’t cut an $800 bill down to $600.
In my experience, most people can find at least a few hundred dollars to cut from their typical monthly spending. It’s very important to emphasize what a huge impact this can make when it comes to eliminating your debt more quickly.
Take this scenario as an example. Jeff has three credit cards, detailed below. His total monthly credit card debt payments are $1,050. In one year alone, Jeff will pay $5,617 in interest. At his current payment rate, the last credit card will be paid off in 2027.
Jeff’s priority should be to free up some cash flow to get these debts eliminated as quickly as possible. Suppose he’s able to find $400 in monthly savings that he can put toward extra payments on his credit cards. The chart below shows the impact of these extra payments.
Paying an extra $400 each month results in Jeff saving over $7,000 of interest expense and paying off his loans almost four years sooner!
Jeff can take his plan a step further by reprioritizing his debt payments by attacking the highest interest rate first. The chart below shows the impact.
Step 5: Consider a temporary decrease to your retirement savings
Wasteful spending is one of the best areas to find excess cash to pay down debts. Another, though less ideal, step you could take is to reduce your 401k contributions. Ideally you’ll still continue to contribute enough to earn your match (that’s free money), but any excess you’re contributing beyond the match could be a way to pay down your high-cost debt more quickly.
There’s a big reason this move is usually justified. Credit card rates are FAR higher than the stock market can be reasonably expected to return over time. The stock market has historically returned about 8% per year. In Jeff’s case, his credit cards cost him anywhere from 18% to 25% each year.
Put another way, if you have $1,000 in the stock market and it gains 8%, you have $1,080 at the end of the year. If you carry a $1,000 credit card balance, you owe $1,180 at the end of the year. I’m no rocket scientist, but that math doesn’t seem to work. Even worse, the rate of return in the market isn’t guaranteed, but the interest cost of your credit card balance is.
If Jeff is able to skim an extra $300 dollars off his retirement savings temporarily, he’s now putting $700 extra toward is debt payments each month for a savings of over $9,000 interest, with all debts paid off in about two years.
Step 6: Consider a HELOC or balance transfer
In some cases you can’t cut enough of your spending to get yourself out of the high-cost debt spiral, so more drastic measures may be warranted.
Using a Home Equity Line of Credit (HELOC) could be one approach. This involves taking a loan from the equity in your home, and using the funds to pay off part of all of your credit card debt. You’ll have a new loan to deal with, but your interest rate will be far lower than your credit card, around 5% or so depending on your credit score.
A credit card balance transfer is another approach, though less ideal. This is a more of a “kick the can down the road” plan where you open a credit card that charges you 0% interest (for a short period of time), transfer the balance of one or all of your cards to the new card, and start aggressively paying it down.
If you have no plans to pay off your debt aggressively then I wouldn’t suggest this approach. Once the 0% grace period is over, the rate sky rockets substantially. Furthermore, there is a balance transfer fee, typically around 3% to 5%. So if Jeff transferred his $20,000 credit card debt to a new 0% card, his new balance would go up to somewhere around $20,600 to $21,000.
What do you think? How much high-cost debt do you think you could crush using this plan? Give it some thought and put it to work.
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