Money Talks, So Should You

4 tools you can use to lower your debt

Jeff Brown
by Jeff Brown, MainStreet contributor

Most credit card users know it is folly to rack up big balances and pay interest and penalties for years. But as the pricy holiday season winds down, let’s be realistic: Sometimes you have no choice but to carry a balance for a while.

This is a good time, then, to look at the fine points of whittling a debt over time. Using debt calculators can give a complete view of the pros and cons of various options such as consolidating debt to pay a lower interest rate, directing bigger payments to the most expensive card or simply paying a bit more than each card requires.

There are a couple of underlying principles. First, the top priority is to avoid missing payments. A missed payment will trigger a costly penalty, could get you a higher rate on your remaining debt and could damage your credit rating.

READ: Talk your way out of credit card debt

Second, it makes sense to direct extra payments to the debts charging the highest rates. Paying $100 on a debt charging 15 percent is like earning 15 percent in a savings account, since it will save you $15 a year in interest charges. The same $100 would “earn” just 8 percent on a debt charging only 8 percent.

Third, maximizing your payments has a snowballing effect, similar to the compounding you get in an investment. As the debt gets smaller, a bigger portion of each subsequent payment goes to paying down debt rather than interest. If you paid an extra $100 a month, each month’s payment would take a bigger bite out of your outstanding balance.

Let’s look at what the four debt calculators can tell us, starting with the BankingMyWay Credit Card Minimum Payment Calculator. With the default figures of $5,000 in debt charging 18.9 percent and a minimum payment of 4 percent of the balance, it would take nearly 13 years to pay off the debt, with payments totaling more than $8,000. Cut the interest rate to 10 percent — something you could do by transferring the debt to a cheaper card — and the payoff time drops to about 10 years and total payments to about $6,300, a significant savings.

READ: Q&A: What’s the ideal credit limit to debt ratio?

Increasing the payments from $200 a month to $300 can also cut the interest cost dramatically, even if the rate remains at 18.9 percent. Total payments drop to about $6,750 and the debt is paid off in just under eight years.

The Personal Debt Consolidation Calculator shows how much you could save by paying off several loans with a new loan charging a lower rate. You might, for instance, take out a low-rate home equity loan to pay off several credit cards and a car loan.

While consolidation loans are often seen as a convenience, reducing everything to one monthly payment, note that it does not make sense to include loans that charge less than the consolidation loan does. If you had a 5 percent car loan, for instance, it would be unwise to wrap it into a consolidation loan charging 8 percent.

READ: Get out of debt: Credit counseling

The Credit Card Payoff Calculator is useful if you have a single card. It shows how much you can save by boosting your monthly payment and how much faster you could pay down the debt.

Finally, the Accelerated Debt Payoff Calculator shows the ultimate strategy: consolidating debts to reduce the interest rate, plus paying more than required each month.

That final element — paying more than the minimum — is essential. The minimum payment required is so small it will take years to rid yourself of debt, and interest charges will be stiff even if the rate is modest. There’s no getting around the fact that to free yourself of debt in the quickest, cheapest way, you have to tighten your belt to boost your payments.

For the past 20 of his nearly 40 years in journalism, Jeff Brown has written about personal finance, economics and the financial markets. He has been a staff writer at The Philadelphia Inquirer and other papers, and in his six-year freelance career has been a columnist for TheStreet.com and the Nightly Business Report on PBS and blogged for The New York Times, MSNBC.com and other Internet sites.