Any financial planner or loan officer will tell you that you can’t borrow your way to wealth, especially when your debt takes the form of revolving loans and credit card balances. Such debt is the number one obstacle faced by most Americans in their journey toward financial health. According to a recent survey by Bankrate.com, less than half (48%) of credit card holders believe they can ever escape credit card debt, and 27% feel less confident of getting out of hock to a credit card company than they did a year ago.
Obviously, the more of your monthly cash flow that must be dedicated to servicing debt, the less you have available for building long-term financial security through savings and investment. But the good news is that there are some things you can do to be a smarter debtor. Following are a few best practices for debt that you can use to keep your debt under better control.
1. Understand your monthly cash flow. If you don’t know where you are with your monthly income and expenses, it’s pretty hard to figure out how to get where you want to go. So, the first step in getting a handle on your debt is getting a handle on your monthly cash flow. The best way to do that, of course, is to establish a budget. Budgeting doesn’t have to be complicated; a simple listing of regular income on one side and all recurring monthly payments on the other, with totals for each column, will work just fine. Or you can use a spreadsheet program to make it easier. And for those who are more technically inclined, there are plenty of online budgeting tools that can make it even easier. Some are free, and most offer a free trial period. The important thing about budgeting is that it helps you really look at where your money is going, each month, including which credit cards and other loan payments are soaking up the most of your income. It can also show you places where expenses can be cut. This knowledge will help you make a strategy for getting your debt under control.
2. Use a bill pay service. Almost all banks offer a free online bill pay service, and this is one of your best tools for staying on top of your debt and avoiding extra late fees and higher interest charges. Consider setting up autopay for charges that recur monthly in the same amounts (mortgage/rent, car payment, insurance premiums, subscriptions, etc.). But be careful with autopay agreements for charges that vary; an unexpectedly large bill (a seasonal surge in utility expense, for example) can coincide with a temporary lull in your cash flow to create both overdraft charges and potential late-payment expenses. For these, rather than autopay, consider a monthly calendar reminder that will allow you to make sure you’ve got the charges covered when they come due. To the extent possible, consolidate due dates around your salary schedule; this will both simplify your cash flow planning and make budgeting easier. Try to keep a buffer of $200 or more in the account you use for paying bills to guard against overdraft fees, missed payments, or late fees. Finally, review your list of bills on autopay regularly to get rid of obsolete subscriptions and payees and to ensure that your payment amounts are still current and correct.
3. Smart credit card use. Yes, credit cards can help you build a good credit score and even provide rewards—but only if you’re using them the right way. In fact, how you control credit card debt may be the most important indicator of the health of your financial plan.
- The number-one rule for credit cards is: Pay on time, every time. Late payments inflict the most damage on your credit score, so set up reminders on your phone and calendars to make sure you know when payments are due and that you have the funds ready.
- If you can, pay off your credit cards in full every month to avoid interest charges and accumulating more debt.
- But if you can’t pay off the entire balance, prioritize larger payments (as much as possible above the minimum required payment on your statement) for cards with the highest interest rate (APR).
- When that card is paid off, add the amount of the payment you were making on it to the payments for the next card on your list. By using this “snowball debt payoff plan,” you can keep the amount dedicated to monthly debt service the same, but increase the rate at which you’re paying off your cards. This “debt avalanche” can then free up more of your money for more profitable purposes.
- Limit the ongoing utilization rate for your credit cards to something between 10% and 30% of the maximum allowed balance. In other words, if your credit card limit is $10,000, try to keep the balance owed between $1,000 and 3,000 (though a zero balance would be better, of course). The lower your utilization rate, the better your credit score.
- Consider making payments on your credit cards in mid-cycle, rather than waiting until the due date, to keep your reported balances lower.
- Don’t close out your old cards, even if they’re paid off; keeping the account open provides a longer credit history, which is preferable to many potential lenders.
- Understand your card’s benefits and rewards programs and use them strategically. If most of your credit card usage is for groceries, make sure your “cash-back” or other program counts grocery purchases. If travel is your goal, try to pick a card with good travel points that still has a reasonable interest rate and low (preferably, no) annual fees. And remember that paying interest tends to negate the value of your rewards.
- Use the perks your card entitles you to (you’d be surprised how many people don’t). If your card offers travel insurance, extended warranties on purchases, fee-free foreign transactions, or other benefits, take advantage of them. After all, you’re paying for them!
- Avoid cash advances. They come with immediate interest charges, high fees, and no grace period on repayments.
- Monitor your accounts. It should go without saying, but especially in the era of online fraud, your credit cards are a prime target. If possible, set up alerts for purchases over a certain amount, for online or international charges, for balances approaching a certain threshold, for payments due, for credit limit encroachment, and other potential signals of fraudulent activity. Most banks and credit card companies offer these for free, but you should make sure. If possible, review your credit card transactions weekly, watching for unrecognized vendors (even if the amounts are only a dollar or two; such “test charges” often signal a forthcoming fraudulent charge that is much larger), duplicate charges, or increases in recurring charges such as subscriptions. And by all means, when you get your monthly statement, take the time to look at it; some fraud only shows up on your statement, and you may also catch billing or other errors.
4. Understand your credit report. You are entitled to one free report each year from the three major credit reporting agencies: Equifax, Experian, and Transunion. In fact, recently, these three agencies have extended a pandemic-era program that allows for free weekly reports (sadly, this is likely due to the burgeoning of online fraud). Even if you don’t feel the need to do it weekly, you should periodically examine each of your reports, watching for:
- New accounts you didn’t open;
- Incorrect loan balances;
- Applications for loans or other transactions you didn’t initiate (these are signs of identity theft).
Many banks and credit card companies offer free credit monitoring, which can alert you to significant changes that could affect your credit score. If you suspect fraudulent activity involving your credit, you can use the monitoring services to freeze your credit. This will not prevent you from using your credit card, but it will prevent a fraudulent account being opened in your name. Remember that you must make a freeze request directly to each reporting service.
These days, it’s probably impractical for most investors to avoid debt altogether. But it’s important to remember that how you handle your debt makes a big difference in your ability to build financial security for the future. At JFS Wealth Advisors, we help clients built financial plans that can keep them on track for meeting their most important goals. If you have questions, please let us help you find the answers you need.
