Paying down credit card debt is one of the toughest things a person can do financially. The interest rates on credit cards are sky-high, most people don't understand how payments are calculated, and it's tough to resist the urge to buy on a credit card and put off paying it until later.
Because of these factors, it's common for people to find themselves stuck with a large amount of credit card debt staring them in the face, wondering how they'll get out of it (or if they even can).
But what's the right way to do it? How do you pay down credit card debt in a way that makes any sense?
I'm glad you asked, and we've put together three options for paying down credit card debt. They're organized based on how strong your credit needs to be to complete each strategy, and trust me, there's an option no matter how low (or high) your score may be.
1. Credit Card Snowball (any credit score)
Debt snowballs are probably the most well-known forms of credit card payoff strategies.
Debt snowballs operate on the principle of momentum, using extra money in your budget to tackle one credit card at a time in a particular order. The strategy is for people with either multiple credit cards or multiple forms of consumer debt, like a car loan or a student loan.
Here's how the concept works: you first carve out an extra amount you can pay toward your debts each month. You take that extra amount and add it to the minimum payment required for the first account you are targeting with your snowball. The minimum payment plus the additional amount is paid each month until the debt is finished.
After the first debt is paid, you take its minimum payment as well as the extra amount in your budget and add it to the monthly payment for the next target in the snowball. Once that second debt is paid in full, you add this amount, the extra payment and the minimum payment from the first debt to your next target. And so on and so forth.
There are two forms of debt snowballs: lowest to highest balance snowballs, and highest to lowest interest rate snowballs:
Lowest to highest balance
Lowest to highest balance snowballs attack debts in order from lowest balance to highest balance. The theory is that human beings work best when they see tangible progress towards their goals, and that if they don't see this progress, they're more likely to quit. By making extra payments towards the lowest balance first, you hopefully pay off the debt as quickly as possible, keeping you motivated to attack what's next in line.
The potential con for lowest to highest balance strategies is your higher debts may carry higher interest rates as well. By leaving these debt payments at minimal levels until later in the snowball, you could potentially cost yourself more over the course of time than if you'd followed the highest to lowest interest rate strategy.
Highest to lowest interest rate
This strategy requires you to pay debts off in order of highest interest rate to lowest interest rate. Paying off debts without considering the balance can mean working for a long time to fully pay off the first debt in a highest interest rate snowball. As an example, if you owe $1,000 on a credit card at 5% and $10,000 on a card at 20%, choosing to pay extra towards the $10,000 balance first would mean a long wait to pat yourself on the back for paying off your first debt. But if you can stick with it, attacking the high interest rates with extra payments will lead to long-term savings when compared to the lowest balance strategy.
Let's look at an example of three credit card balances and how an extra $200/month could be put to use in a debt snowball strategy:
With these card balances and interest rates, using the lowest balance strategy would mean paying an extra $200 towards the $2,000 balance first, even though its interest rate isn't the highest of the three cards.
The $5000 balance would be the first target in a highest to lowest interest snowball, even though it has the highest balance of the three cards.
2. Pay down credit cards with a personal loan (Decent Credit)
If your credit score is damaged, but not completely wrecked by your credit card debt, using personal loans to pay down your card balances offers some potential benefits.
Personal loans are offered by lenders to individuals based on the strength of certain factors in their finances, namely their income and their credit score. These loans are a form of unsecured debt, meaning there is no physical asset (a home, a car, etc.) the lender can seize if you don't repay them.
Since the lender's risk is higher, rates on personal loans are typically higher than you'd find for secured debt like a mortgage or car loan. But even with these higher rates, personal loans offer 1.) Rates that still often beat what's available with a comparable credit card and 2.) A definitive payoff date in the future for your debt.
Not only that, using the proceeds of personal loans to pay off credit card debt can potentially improve your credit score even before you paid any money down. Why? It has to do with how credit bureaus view personal loans.
Revolving debt vs. installment debt
We've covered the elements of a FICO credit score and given special attention to a category called credit utilization.
Credit utilization ratios express how much of your available credit you've borrowed at a given point in time. If you have $10,000 of available credit and outstanding balances of $5,000, your utilization ratio is 50%.
You might also have heard of The 30% Rule, which states if your utilization ratio stays within 30%, it won't negatively impact your credit. While there's some truth to this, studies have shown people with the highest credit scores often keep their utilization ratio below 10%. So 'the lower the better' is probably a better rule of thumb than The 30% Rule.
Here's how personal loans fit into the conversation: credit utilization is a huge component of your credit score (30%), but it only considers what you borrowed in revolving debt. Revolving debt allows you to borrow money multiple times up to a set limit. If you have a credit card with a $10,000 limit, you can borrow up to $10,000 endless times as long as you keep paying off the bill. Credit cards are considered revolving debt.
Personal loans, however, aren't considered revolving debt. Personal loans are installment debt, meaning they have set terms for repayment in the money can only be borrowed one time. Mortgages, car loans and student loans are other forms of installment debt, in these types of loans aren't factored in when calculating utilization ratios.
By paying off credit card debt with the proceeds of a personal loan, you've transformed revolving debt – which hurts your credit utilization and credit score – into installment debt that doesn't factor into utilization at all. Not only that, but it also helps lower your utilization ratio even though your total debt is the same.
Let's look at an example:
We have a credit card with a $10,000 limit, and $6,000 owed on the card. These totals mean are utilization ratio on this card is 60%, far too high to benefit our credit scores.
Now let's assume we find a lender willing to offer us a personal loan for $5,000 at a lower interest rate than what we pay towards the credit card. We'll use that $5000 to pay down our card balance, leading to the following results:
While we still owe $6,000 in total debt, the personal loan proceeds help us pay our credit card down to a $1,000 balance. With a $10,000 limit, we now have a utilization ratio of just 10%, a 50% reduction which could improve our credit quickly. The balance of the personal loan isn't reflected in our utilization ratio, and the lower interest rate on the loan will help us pay down our total debt at a lower cost.
3. Credit Card Surfing (Excellent Credit)
This strategy speaks to a much smaller group of people, as you typically need pretty strong credit to implement it in the first place.
Credit card surfing is the concept of continuously transferring balances from one card to other credit cards to take advantage of lower interest rates.
As long as the cardholder has strong to excellent credit, most credit card companies will accept balance transfers from other cards. Even though the transfer is allowed, there is typically a balance transfer fee involved in the exchange of 3% to 5%.
In addition, credit card companies put out enticing introductory offers for first time applicants hoping to lure people with strong credit to their card(s). These offers range from 12 to 18 months and may include benefits like additional rewards points, 0% interest on new charges and, most importantly, 0% on any balance transfers during the introductory period.
Borrowers hoping to pay down credit card debt take advantage of the 0% balance transfers to move credit card debt from an old card at a high interest rate to the new card with the introductory 0% rate. They then pay down as much debt as possible while no interest is being charged, radically reducing their overall costs.
And if 0% rate ends and a balance is still old, the borrower might find yet another new card with a 0% introductory rate on balance transfers and start the process all over again (hence the term credit card surfing or hopping from one card to another).
Let's look at an example an action:
A borrower owes $6,000 on a credit card with a $10,000 limit. In addition to the damage done to their credit utilization ratio, which sits at 60%, the interest rate on this card is likely pretty high.
They scan the marketplace and find an introductory offer with a balance transfer credit card, which grants them 12 months of 0% interest on all transfers with an initial 3% transfer fee.
Let's see what happens if they take $3,000 from their current card and transfer it to the new card:
Transferring the balance means paying a $90 transfer fee (3% of $3,000). This fee can be paid in cash or added to the transferred balance. Once the funds are transferred however, the new balance sits at 0% interest for the entire 12 months. The cardholder can use these 12 months to pay down the debt at a lower cost.
As you can also see in the example, opening the new card increases the total credit available to the borrower, and decreases the utilization ratio on their old card significantly. Rather than owing 60% of their $10,000 limit, they now owe around 30% of their $20,000 in available credit, which could radically improve their credit score as well. These benefits show the pros of credit card surfing in action.
The cons? We already covered that it typically takes excellent credit to qualify for these introductory offers. Not only that, opening a new credit account causes damage to two other elements of your credit score, the age of your accounts and credit inquiries. These two elements combine to represent 25% of your FICO score. So, while the credit utilization ratio is a larger part of your score, at 30%, you can't pinpoint the exact impact opening a new card will have until after you've opened it.
I never said it would be easy, but you CAN get out of credit card debt with some motivation and some maneuvering. Hopefully one of these three methods speaks to you and will help you on your journey, and trust us, that journey won't last forever.