When credit cards turn nasty, these debts can take decades to repay. Here's how to kill them off in record time.
Back in December, in When Balance Transfers Go Bad, I wrote about a friend's struggle to get out of debt. Like many millions of people, Dave (not his real name) has got into trouble through overspending. As a result, he has amassed three separate debts: a credit card, an overdraft and a personal loan.
By my calculation, these debts total more than half of Dave's yearly pre-tax salary. To put it another way, if Dave put every penny of his take-home pay towards repaying his debts, then it would take him perhaps ten months' wages to clear the decks. Of course, this isn't an option, but Dave is determined to turn the corner and throw off this burden as quickly as he can.
So far, we've studied Dave's income and outgoings and then created a ten-point action plan to enable him to repay his debts much faster. His cheap personal loan will be left to run its course. In addition, he plans to sell a few items in order to raise enough cash to repay his overdraft right away. This leaves us his credit-card debt to tackle, which is perhaps his biggest problem.
A Never-Ending Debt
At first glance, Dave's credit-card borrowing doesn't look too awful. Alas, when I dug below the surface, I realised that it was an absolute horror story. Indeed, I warned Dave that, unless things change, his plastic debt would easily outlive him! Here's why:
- Dave owes, say, £5,000 on his credit card (the actual figure is slightly higher, but five grand is a nice -- or not-so-nice in Dave's case -- round number).
- He pays only the minimum monthly repayment (MMR) demanded by his card, which is 3% a month. Thus, this month's repayment is £150.
- He is paying a very high interest rate on his credit card, partly because he has used it to withdraw cash. Indeed, his interest bill is running at £100 a month, or almost 2% of his balance.
- This equates to an annual percentage rate of 26.8% APR, which is almost five times the Bank of England's base rate of 5.5% a year. What an enormous rip-off!
- Dave also has overpriced, nearly worthless payment protection insurance (PPI) on his card, which costs him a further 0.8% of his balance every month. I warned him that he is paying £40 a month for insurance which should cost perhaps a tenth of this sum (£4).
To sum up, Dave repaid £150 of his card balance this month, of which £140 was gobbled up by interest and insurance charges. Thus, he's only repaid £10 of the £5,000, or one five-hundredth (0.2%) of his balance. At this rate, it will take many decades to clear this debt. Indeed, I'm certain that Dave would be dead long before his debt was extinguished!
Money Makeover
Anyway, that's the bad news. The good news is that my money makeover should help Dave to dynamite his plastic debt within three years. Here's what he plans to do:
1. Cut up his credit card and never use this account again, even in emergencies.
2. Cancel his rubbish PPI cover and put the extra £40 a month towards repaying his debt faster.
3. Instead of paying his card's minimum monthly repayments, set up a direct debit or standing order for a flat £200 a month.
Even if Dave did nothing else, these three steps would increase his monthly repayment to £200 and reduce his charges to £100 a month. Therefore, his net repayment would increase to £100 a month, instead of the £10 repaid on his latest statement.
Then again, Dave's biggest problem is the swindling rate of interest that he's paying on this card. Happily, we can slash this to zero if we can arrange a balance transfer of the whole £5,000 to a 0% credit card. Even if Dave can't transfer the entire balance, he should shift as much of it as he can to a new 0% card. If Dave can't get a 0% card, then a lifetime balance transfer card would reduce his interest rate to under 6% a year. This would reduce his interest bill to about £25 a month, instead of the current £100, further accelerating the speedy repayment of his debt.
In conclusion, if Dave takes all of my advice to heart, then I think he could clear his credit-card debt in two to three years -- or even sooner, if he puts his mind to it. That's a lot better than being in debt for the rest of your days, as I'm sure you'd agree!
(PS: For clarity's sake, I have simplified the above calculations. Of course, as your credit-card balance goes down, so too does the amount of your minimum monthly repayments, interest bill, PPI premium and so on. However, this doesn't really affect my overall message.)
More: Get a cracking 0% credit card via the Fool | Watch Out For These Terrible 0% Traps | Why Can't I Get A Credit Card?