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Trying to dig out of credit card debt can often feel like treading water. Although you’re making those payments every month, you still can’t seem to get ahead. Unfortunately, lots of you grappling with credit card bills thwart your efforts to become debt-free by making a huge financial mistake: even though you barely see your balances budge, you continue to pay off their credit cards with the highest interest rate first, under the assumption that doing so is always the best way to have zero debt. In reality, nothing could be farther from the truth.
I know this is going to sound like financial heresy to many of you. After all, every personal finance book you’ve read and every financial expert you’ve heard discuss this subject has said the same thing: pay off high interest rate debt first. Well, I hate to shock you, but there’s a huge problem with this age-old advice: it doesn’t work for most people. Even worse, following this well-intentioned but misguided advice could cost you money, damage your credit rating, and put your financial health at risk in unintended ways.
Let me first explain why the oft-heard admonition to focus on your high interest rate debt is wrong-headed. Then I’ll tell you a better way to prioritize your debts and choose the most effective method way to pay off your credit card bills. Trust me: when you’re done reading this section, you may have an “Aha” moment about why you haven’t been able to pay down your credit cards bills faster.
Four Enormous (and Wrong) Assumptions
When personal finance gurus advise you to pay off high interest rate debt first, they are making the assumption that:
- the interest rates on your credit card are high
- you are bothered by your credit card interest rates
- this strategy is the fastest route to paying off your debts
- you’ll save the most amount of money by using this technique
These are four enormous assumptions. Unfortunately, for millions of Americans who are deep in debt, these suppositions are flat-out wrong. Here’s why.
Be Glad the 1980s Are Gone
For starters, credit card interest rates are not at sky high levels. Most lenders use the prime rate as their benchmark for setting interest rates on credit cards, home equity lines, auto loans and other personal consumer loans. The prime rate is based on the federal funds rate. Set by the Federal Reserve, the fed funds rate is the rate that banks charge one another to borrow money overnight. As of October 2008, the prime rate in the United States stood at 4.0%, and the fed funds rate was 1.0%. As a result, standard credit cards with fixed interest rates average 13.42%, while credit cards with variable interest rates average 11.33%, according to Bankrate.com. By comparison, the prime rate peaked at 21.5% in December 1980, and in the mid-1980s, credit card interest rates averaged a record 18.75%.
What’s Really Bugging You?
When it comes to your credit cards, think for a moment about what really drives you nuts. Most financial advisers make the erroneous assumption that all consumers are upset about high interest rates, but often that is not the case at all. I remember when I had $100,000 in credit card debt back in 2001. Fortunately, I managed to pay off my debts in three years without ever missing a payment. Because of my track record, I had leverage to negotiate with my credit card companies. I asked for, and received, lower interest rates on nearly all my credit cards. At one point, none of my cards carried an interest rate above 6.9%. In fact, several cards had 0% interest, while others were at 2.9% or 4.9%. In short, I wasn’t bothered at all by my interest rates, because they were very manageable.
High Dollar Balances
What did bother me, however, was that my cards all had high dollar balances. Because I’d been an over-spender, I was maxed out on many credit cards, and those cards that weren’t maxed out were approaching their limits. Imagine my angst when I had the nerve to go out to dinner at some fancy New York restaurant. Despite the risk of public embarrassment, I’d plunk down a credit card to pay for the bill and then had to cross my fingers – and say a silent prayer – in the hopes that the card would be approved!
Next – Day 25: Pick a Proper Debt Payoff Strategy (Part 2)
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Lynnette is a personal finance expert, author and speaker.