Let us look at a specific example of someone dealing with credit card debt –
Paul has two credit cards in his name and has created 4,000 in debt between them. Both cards have an ARP of 14.9 percent.
Paul was only making the minimum monthly payments of £120 and is noticing he has not made a dent in the overall balance.
If he continues to handle his credit card debt in this way, it would take him almost 18 years to clear the balances on both cards and will have paid over £2,700 in interest alone.
The Zero % Effect
In an attempt to correct the debt, Paul found a company willing to offer 0 percent interest on balance transfers and 0 percent interest on purchases for eight months. When he applied for this card, he was given a £4,500 limit and transferred his outstanding debt.
A transfer fee of £120, three percent of the total balance transferred, was added to his new balance which now totaled £4,120. Every month Paul is required to pay three percent of his current balance and three percent of any new charges.
What Paul did not realise is that new purchases would be paid off first, causing further debt problems. Three months after obtaining his new card, Paul made a £300 purchase and paid what he believed was the correct amount the next month – three percent of the total balance.
This payment, however, was applied to his new spending and nothing was deducted from the balance. When Paul realised what happened, he quickly paid off the new spending and continued payments to reduce the card’s balance.
What are Paul’s Options?
Paul still desires to pay off the entirety of his credit card debt without having to deal with large interest charges. To accomplish this goal, he has some options he can consider:
1. Use a Loan to Pay Off the Credit Card Balance: Paul can take out a bank loan with a lower interest rate to pay off his credit card debt. The interest rate on this type of loan will vary depending on which financial institution he chooses.
2. Continue Making Monthly Payments: Paul can continue to make monthly payments on his current credit card. He would start by paying £120 a month during the no interest period. After that, he will be incurring a 14.9 percent interest charge and still only be able to afford the £120 payment. In the end, he would be paying £632 in interest and making payments for 31 months.
3. Pay the Minimum Amount and Invest: Paul could pay the minimum payment for the eight month interest free period and invest any additional funds in an interest-bearing account. After the interest free period is over, pay off as much of the balance as possible with the invested funds and take the card’s remaining balance to another credit card deal or take out a low-interest bank loan.
Paul chose the third option – at the end of the interest free period, he took out a bank loan for 30 months at a 7.9 percent interest rate. Over that period, Paul had saved around £60 which was put toward his balance before taking out the bank loan.
At the end of this process, his monthly payments were approximately £115 and he had paid a total of less than £350 in interest.
How Can You Avoid Credit Card Debt?
There are a few key things to keep in mind when you want to avoid building up debt from credit card use. First, make sure to monitor spending with credit cards and not spend more than you are able to reasonably pay off. Remember that credit cards come with interest rates, purchasing items with them is more expensive.
Finally, when in the market for a credit card, shop around for the best deals and lowest interest rates and make sure to fully understand all terms and conditions.