Money Management

Money Management Problem – Credit Card Debt

Madison over at My Dollar Plan invited her readers to comment on a question she received from a friend about how to get rid of $14,300 in debt. I have never faced debt like this, so what I have to offer is only theory crafting – but I like crunching numbers so I figured I’d give it a shot. According to Madison, the debt is distributed in this way:

  • Personal Line: $3,500 balance @ 15% – $7,000 limit
  • Credit Card #1: $2,300 balance @ 9.6% – $5,000 limit
  • Credit Card #2: $6,600 balance @ 8.5% – $8,000 limit
  • Credit Card #3: $1,900 balance @ 18% – $2,000 limit

Currently the person pays of their debt in this fashion:

  • PL: $210 per month
  • CC #1: $0 per month
  • CC #2: $1,200 per month
  • CC #3: $100 per month

For the sake of the experiment I am going to make some assumptions about this individual. He currently is using all his extra income to pay down his debt (the $1,510 shown above) and he is unable to get a credit card with 0% interest. I am doing this to remove the idea of getting another credit card at 0% interest and transferring the balances over to that card. It is a great idea, but just isn’t any fun to crunch the numbers on. Also, the credit card company charges interest on the largest balance within the billing month, so if there is $2,300 on a credit card on July 1 he will have to pay interest on all $2,300. The minimum payment for each card is 100, which I will make to avoid late fees.

From the get go this dude is in trouble (given my assumptions). Given his current payment plan his debt will shrink significantly, by 48.8% over a five month period (jumping to $7,319). Not too bad.

There is one major method that people generally employ when facing this kind of debt: the debt snowball. The way a debt snowball works is that as you pay of a debt you use the money that you were using pay back that particular debt (i.e. credit card debt) to be used in paying off other debt (i.e. another credit card). This a proven method for success. However, not everyone agrees on how a person should prioritize which debt to pay off first.

There are two prevailing schools of thought in when it comes to money management in a debt snowball. The first is to pay off the lowest balance first. This is the view of Dave Ramsey. If our in debt friend were to employ this method his debt would look something like this after 5 months:

  • Personal Line: $1,928 balance @ 15% – $7,000 limit
  • Credit Card #1: $0 balance @ 9.6% – $5,000 limit
  • Credit Card #2: $6,328 balance @ 8.5% – $8,000 limit
  • Credit Card #3: $0 balance @ 18% – $2,000 limit

In all his debt will only have gone down by 42.27% (a total of $8,256 outstanding) over the same five month period. This is worse than paying off his debt as he is now!

The other version of the debt snowball is to pay off the highest interest rate first. This scheme is designed to reduce the interest you will be forced to pay on your money over the life of you debt. This strategy will have the following results:

  • Personal Line: $0 balance @ 15% – $7,000 limit
  • Credit Card #1: $929 balance @ 9.6% – $5,000 limit
  • Credit Card #2: $6,328 balance @ 8.5% – $8,000 limit
  • Credit Card #3: $0 balance @ 18% – $2,000 limit

With this strategy his debt will have been reduced by 49.25% (a total of $7,257 outstanding), a marked improvement on the Dave Ramsey version of the debt snowball but only slightly better than his current debt strategy.

This person should employ a debt snowball approach that focuses on interest rates to pay down his debt. Though his debt only decreases slightly more than the his current payment plan, my experiment did not include late fees for missing payments which could have made the difference between the methods significant. It just goes to show you though, living debt free is the way to be.

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