Digging Yourself Out of the Hole

Dear Reader,

Congratulations. Not for amassing $6,000 in debt, but for recognizing that it's an issue you need to address now, while you're still young.

Too many young adults fall into the trap of credit card debt. (I'm assuming that the $6,000 you owe is to credit card companies and wasn't incurred buying a car or some other big asset.) But too few seem to realize just how deep a trap credit cards can pose. In fact, about one third of all personal bankruptcies are filed by people under the age of 35. And it's not the least bit surprising: It's easier than ever to get credit cards, and people who are in the early stages of their careers typically don't have big incomes.

I'm not going to give you the traditional advice for someone struggling with credit card debt: cut up the cards and claw your way back. Credit cards aren't the problem, and they're pretty essential for modern life (try to rent a car, buy an airline ticket, or make an online purchase without one). Only if your card use was somehow pathological would I suggest getting rid of them entirely. I do, however, suggest that you get rid of any store-specific credit cards since they typically have the highest interest rates, and keep only one or two bank-issued cards.

More likely, your problem is using credit cards to pay for a lifestyle you can't quite afford. In fact, it seems like too many people are using their credit cards to pay for relatively small purchases - a couple of lattes at the coffee shop or a movie ticket - which quickly add up.

Taking charge

Your first step to getting out of debt is to understand where your money is going. Keep track of your spending for a few weeks, and based on that information, create a budget that you can stick to. The second step is to get in the habit of paying with cash as often as possible. It's just human nature that we tend to spend a little less when we deal in hard cash. Somehow, plastic makes the purchase seem less real. So, I recommend giving yourself an allowance: Go to the ATM once a week, take out the cash you'll need for daily expenses, and use that for as many purchases as possible.

The result of these fairly minor shifts in behavior should be that your credit card balance will stop growing. But how do you pay down the balance and eventually get it to zero?

Again, the conventional wisdom - pay it off as fast as possible - is not necessarily what I recommend for someone your age. Rather, you need to pay down your balance as soon as possible - but not at the expense of taking advantage of high-yielding savings opportunities such as an employer match on your 401(k). I believe you need to pay yourself first, so that you can start building assets even as you reduce liabilities. Now is the time you should get in the habit of saving and investing, particularly if you're getting a 100% return on your investment through an employer match.

Paying off your debt

At the same time, you need to pay down your card balance at more than the minimum rate. I ran a few numbers to show you how paying more than the minimum pays off big-time.

The average rate for credit card debt is about 13%, and you owe $6,000. If you paid $120 each month (2% of the original balance, typically the standard minimum payment) and incurred no additional charges, you'd pay off your debt in six years at a total cost of $8,689 ($6,000 plus $2,689 in interest payments).

But if you could increase your monthly payment to $300 a month, you'll pay off the debt in less than two years at a cost of just under $6,800 (a little less than $800 for interest). Personally, I like to use online banking to make this type of transaction automatic.

Finally, it's worth checking to see if you can reduce your interest payments by transferring your balance to another card with a lower interest rate. Or, if you own a home, you can take out a home equity loan, which will certainly be a lower rate than your credit card (and for some people in some situations, can be tax deductible).

Again, congratulations on taking a big first step toward financial maturity (and solvency). And as you reduce your credit card liabilities to zero, work on increasing your assets through saving and investing.

(0906-6023)