Credit card debt isn’t the same as a personal loan or mortgage. It differs from these other forms of debts in significant ways.
Let’s look at what sets credit card debt apart and how it can impact your credit reports, your available income, and your quality of life.
Types of Credit
Creditors offer various types of credit to serve specific purposes. The two basic categories are revolving credit and installment credit.
Revolving credit
Credit cards fall under the category of revolving credit. Other forms of revolving credit include a personal line of credit, home equity line of credit, retail cards and gas cards. Revolving credits allows you to borrow without a physical asset, such as a house or car (unsecured).
The idea is that you can use your card up to the credit limit, providing you repay what you borrow, plus fees and interest. You must pay at least the minimum payment during the billing period.
However, most cards offer a grace period of between 21 and 30 days after the end of the billing cycle. If you pay the balance in full during this time, you do not pay interest.
Installment credit
Installment accounts typically have a fixed payment that you make until you pay off the balance. Examples include an auto loan, student loan, personal loan, or mortgage. They may or may not have a fixed interest rate throughout the life of the credit product. Some installment loans are linked to an asset (secured) to guarantee the lender gets their money.
How Does Credit Card Debt Affect Your Credit Scores?
The credit reporting agencies consider many factors when they calculate your credit scores. One of these is your credit utilization rate. This rate compares the amount of money you owe to how much credit you have available to you on your credit cards.
As an example, you have a credit card with a limit of $5,000. Your current balance is $2,500. Your credit utilization rate on the card is 50 percent.
However, your overall credit utilization rate includes all your revolving credit. If you have another card with a limit of $10,000 and a balance of $7,000, your credit utilization rate is 70 percent on the card, but 60 percent overall (50% + 70%/2= 60). The two totals are averaged. Read more on credit utilization rates.
So, what’s an optimal credit utilization rate? Transunion suggest below 35%, Equifax recommends 30%, and Experian claims those with the best credit scores have credit utilization percentages in the single digits. The idea is that you should use, but never abuse, your revolving credit.
Factors that can affect your credit utilization rate include closing existing credit card accounts. This reduces the amount of credit available to you and increases your credit utilization rate. Keep existing accounts open, if you aren’t going to use them.
You should also limit how often you apply for new credit as many lenders use a hard inquiry to check your credit report. This causes a dip in your credit score.
Are Interest Rates Higher on Credit Cards?
Generally, yes. The current average Annual Percentage Rate on a credit card in the U.S. is 27.65%. Compare that to an installment loan through a commercial bank of 8.57% and you can see there is a huge difference.
Of course, the rate you can get on an installment loan depends on your financial situation as does interest rates on credit cards available to you. Yet, it is almost always true that carrying debt on credit cards will cost you more due to the way lenders calculate interest. Typically, you pay compound interest.
What is Compound Interest?
Compound interest works in your favor when you save money. The interest the lender pays you on your deposit is added to your bank balance. As your balance grows, so does the interest paid.
However, compound interest does not work in your favor when it comes to credit card debt. If you do not pay off your entire balance, interest accumulates on what remains.
The interest charged increases your total debt amount and when the next month rolls around you pay interest on this new higher balance. Regrettably, this is often the reason why consumers find themselves drowning in credit card debt. They underestimate how quickly compound interest grows and increases debt.
Average Credit Card Debt
The average credit card debt for an American household is $7,951. Gen X tend to carry the most debt, followed by Baby Boomers and Millennials.
Unfortunately, carrying too much credit card debt always leads to negative consequences. Your credit scores can suffer, particularly if you miss payments. This can hinder your financial future. Interest charges can also make it hard for you to make ends meet.
Signs Your Credit Card Debt is a Problem
You may have read the figure above and thought, “Oh good, I have less debt than that”, but don’t fool yourself. There are telltale signs that you’re not handling your credit card debt well that extend beyond this dollar amount.
One survey found over half of Americans can’t pay off their credit card balances each month. This means they always pay compound interest. What’s worse is that many people only make minimum payments, so their balance grows and grows.
Here are a few signs that you probably have credit card debt problems:
- Never or rarely pay off credit card balances
- Often make minimum payments
- Constantly use one credit card to make payments on another
- Take cash advances regularly
- Miss payments and incur late fees
- Go over credit limits
- Open new accounts to access more credit
Options for Dealing with Credit Card Debt
If you exceed the average credit card debt amount mentioned above or you meet one or more of the signs of debt problems, you have options and you can regain control.
Cut Up Your Cards
This may seem extreme, but it will certainly stop you from racking up more debt. If you have more control, simply stop carrying your cards and disconnect them from your pay apps. Use your debt card or cash and only buy what you need.
Create a Budget
A budget provides guidelines of how you spend your money based on how much you make. It’s not hard, but it is essential if you want to stop accumulating credit card debt. You will need to allocate more money towards debt payments too.
You will also need to set realistic goals and make yourself accountable if you want to pay off credit card debt. Many people pay off their smallest debts first to build momentum. Others pay off the debts with the highest interest rates to save more money upfront.
Credit Counseling
The National Foundation for Credit Counseling is a non-profit that can help you create a budget. They may recommend debt consolidation or a debt management program to get your finances back on track.
They will also tell you if your credit card debt is too high for you to effectively manage it. Don’t assume this is the case, because bankruptcy stays on your credit reports for up to ten years. Seek professional advice first.
Debt Management Program
A debt management program may help you repay your credit card debt, without taking out a loan. However, it isn’t without drawbacks.
The program usually runs for three to five years and only between 55% and 70% complete it. Participants must commit to consistent payments and close existing credit card accounts. They can’t open new credit accounts while they’re in the program either. Definitely talk to a credit counselor to find out if this is the right route for you.
Debt Settlement
Debt settlement companies work to negotiate lump sum settlements with your creditors. You pay a monthly payment to the settlement company and these payment are meant to go towards the amount owed to your creditors.
Obviously, this sounds like a very promising option, but there is much to consider. First, this process often has a negative impact on your credit score. Second, credit card settlements are often taxable. Finally, not all debt settlement companies are legit or effective. It’s up to you to find a reputable one.
Consolidate Credit Card Debt
If you’re wondering how to pay off credit card debt, a credit card consolidation loan is one of the most common solutions. It is a personal loan used to pay off all your credit card balances.
You pay a single payment and the interest rate on your loan never fluctuates. The lender also charges simple, not compound interest. This costs you far less.
Your consolidation loan also has the potential to boost to your credit scores. Creditors appreciate accounts paid in full and if you’ve never had an installment loan, you’ll increase your credit mix. Make timely payments and you also strengthen your credit history.
Eliminate Credit Card Debt Today
Fortunately, even if you have a substantial amount of credit card debt you can get your finances back under control. FlexMoney’s extensive network of lenders may offer the best way to pay off credit card debt.
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