Most personal finance columns in December are filled with words of wisdom on how to avoid spending too much during the holidays. And every January we see stories on how to deal with debt. Unfortunately we seem to follow the same painful cycle: overindulgence in December and then a new year's resolution in January to deal with the consequences.
Even worse, the $986 is incremental debt. Forty percent of the country entered the holiday shopping season with over $10,000 of debt. Meanwhile, credit card companies continue to fuel the fire. Experian Decision Analytics regularly releases data on credit card growth, and new credit cards are being issued at an amazing speed. Banks granted $92 billion of new credit lines between July and September 2014. That is an increase of 35 percent compared to the same three months a year ago. Americans are being given more opportunities to borrow, and it looks like they did just that in December.
Where there is pleasure, guilt often follows. And we see the guilt and new year's resolutions on full display. Last year, more people searched Google for "get out of debt" during the first weeks of January than any other time during the year. We all seem to wake up on Jan. 1 and decide to eat healthy, lose weight and get out of debt. The ambition is admirable, but how can we make sure that we stick to it during the year?
A Plan to Be Debt-Free
The math of getting debt free is simple. There are two ways to get out of debt faster: make bigger payments each month (which means you have to earn more, spend less or both) and reduce the interest rate on your debt (by transferring the debt to a lower interest rate).
The psychology is a lot harder. We are human beings, and good intentions often give in to desire. Surprises happen. We lose our job, or we lose that extra shift. Our landlord increases the rent more than expected. There are so many different ways that we can be diverted from our goal of debt freedom. But that doesn't mean we shouldn't try.
And we should harness our good intentions in January to take measurable action. To give this January's resolution a greater chance of sticking, I have written a guide on how to pay off debt. And the most important part of building a credible plan is having a realistic assessment of your situation, so that you can follow the plan that will fix your situation the fastest.
How Bad is My Situation?
There are three important parts of your situation:
- Do you spend more than you earn each month?
- How good is your credit score?
- How much debt do you have, relative to your income?
If you spend more each month than you earn, you will never get debt-free. That may sound obvious, but far too many people don't understand the difference between cash flow and spending. When you buy something, you are spending money. When you pay the credit card bill, you are just paying for something you already bought. Just because you can afford the minimum payment on your credit card does not mean you are spending less than you earn. And if you can't comfortably cover your fixed expenses, you will need to take some drastic measures. That could include moving to a cheaper home or apartment, selling an expensive car or re-considering some other big expenses.
If you have already accumulated too much debt, you should seek credit counseling and consider re-structuring or, potentially, bankruptcy. Once your credit card debt is more than 50 percent of your gross income, it will be very difficult to recover from that situation. Cutting out a trip to Starbucks (SBUX) or selling a few items on eBay (EBAY) will not make a material difference to your situation. When you can barely afford the minimum due on your credit card payments, it is time to negotiate. You don't want to spend the rest of your life working just to pay interest on your debt. Banks will be happy to take the minimum payment each month, but it does reach a point where struggling to make the minimum payment is no longer in your best interest.
Can You Transfer and Attack?
And, if your credit score is below 700, it will be challenging to re-finance your debt to a lower interest rate. You really need to work on building your credit score, so that you can create options to transfer. In order to build your score, you need to understand how scoring works and focus on the parts that matter. That means keeping your total utilization (your statement balance as a percentage of your credit limits) below 20 percent, and paying on time every month.
But, if your debt is below 50 percent of your income and you have a score above 700, you can transfer and attack. That means you can take high-interest credit card debt and transfer it to a low-interest rate options. There are some amazing offers out there, especially from credit unions. For example, American Heritage Federal Credit Union (which anyone can join) offers 2.99 percent for 24 months on credit card balances transferred. If you have $5,000 of debt at 17 percent, you could save nearly $1,000 by transferring that debt. At MagnifyMoney, we keep a list of the most current offers, and we do the math on the savings.
To make a real dent in your debt, you should take action now. But what type of action depends upon your situation. If your fixed expenses are too high, moving to a different apartment may be the best thing you can do. If your debt is close to 100 percent of your income, finding a nonprofit consumer credit counselor is probably the best thing you could do. And, if you have a great score but just have too much debt, refinancing the debt could be the best action you take. Even if you don't cut your spending, more of your monthly payment will go towards principal every month. We all know we have the risk of getting lazy in a few months time, so lets take action in January that sticks for the rest of the year.
Nick Clements is the co-founder of MagnifyMoney.com, a price comparison website that helps you find the best deals in banking. He spent nearly 15 years in consumer banking, and most recently he ran the largest credit card business in the U.K.