I received a reader question last night, and I thought I would address it in the form of an article to share with everyone, and so readers can weigh in with their thoughts. The question deals with the coming economic stimulus check and using that to pay off debts. The reader’s question deals with deciding which debt to pay of first.
Here is the question:
I am trying to decide what to do maybe you can help me decide. We have three credit cards with a low limit on all but they are maxed out and we are accruing late fees every month, sometimes over 30 days! I thought I should pay those off but on the other hand my husband’s car loan has a super high interest rate and I know we really need to get rid of it so I thought we could trade it in and put the $1800 towards a down payment on something new. I just can’t decide what to do!!!
K., thanks for your question. First, I want to let you know that I am not a financial professional, so I can’t and won’t tell you exactly what you should do. But I can make a some observations about your situation. In the end, you need to do what you feel is best, or consult with a financial professional.
What we know about the debt situation:
- 3 maxed out credit cards with low limits
- Regularly accruing late fees.
- High interest auto loan
- $1,800 rebate check.
What we don’t know about the debt situation:
- Interest rates
- Loan amounts
- How much late fees cost
- Other debts, bills, expenses, etc.
Where should we start?
Facing a mountain of debt is never an easy task. It can be confusing deciding where to start and how to attack it. Thankfully, there are a lot of great resources that can help you make these decisions.
Recently, a group of bloggers, including myself, wrote an series based on the teachings of Dave Ramsey, who specializes in getting out of debt, staying out of debt, and planning for a prosperous future. The lessons we wrote about are known as his Baby Steps to Financial Peace. Reading the entire Dave Ramsey’s Baby Steps series is a good place to start to get some great ideas on how to get out of debt and become financially free. I will summarize a few of the steps that are most applicable to your current situation.
No more debt, get current, and build a budget
Make the decision to eliminate your debt. You and your husband have already decided to do this. Congratulations! Making this decision is the first step to getting out of debt. Without making the decision to change your old habits, you would remain in debt indefinitely. Now you need to form a plan on how to get out of debt and stick to it!
Get current on your debts. You mentioned paying regular late fees on your credit cards. Late fees run about $30 or more each and will eat you alive! If you are paying three different late fees per month, you are probably adding an additional $100 per month on top of a payment you are already struggling to meet. That is $100 per month that could be used to pay down other debts, such as eliminating the credit cards completely, or paying down the car loan more quickly.
Understand your financial situation – start with a budget: The most important thing you and your family can do at this point is understand your financial situation. Starting with a budget is a great way to do this. My friend Lynnae wrote a great primer about how to build a budget for the first time. There are many tools you can use to help you make a budget, but if all you have is paper and a pencil, that will work fine. You just need to do it.
Reduce interest rates
You may be able to contact your credit card companies and ask for a reduction in interest rates; some companies are willing to reduce interest rates provided you make on time payments. Another option is to do a 0% balance transfer, which allows you to transfer your credit card debt to a 0% interest credit card. Here is a list of featured balance transfer cards.
Start an emergency fund
Once you are current with your loan payments, you need an emergency fund. An emergency fund can be used for many things – the most important of which is to give you a financial cushion to help prevent the need to borrow more money when a large, unplanned expense comes up. These can include car repairs, medical expenses, home repairs, sudden loss of a job, etc. The recommendation is to start with a $1,000 emergency fund, then start working on repaying your other debts. Read more about emergency funds.
Pay off all your debts using the “debt snowball”
Dave Ramsey coined the term debt snowball, which refers to his method of paying off your debts. Start with the smallest debt and when you pay it off, add the amount you were paying for that loan to the payment you are making on your next smallest loan. When that debt is repaid, repeat the process. The key is not to reduce the payments you are already making, so each time you pay something off, your debt payment gets larger and larger – much like a lot of little snowflakes add up to make… a snowball. One snowflake isn’t very powerful, but a lot of them together are powerful.
These steps are a great place to start your debt reduction
You mentioned your tax rebate will be $1800. That will probably be enough money to start on these steps.
Get current. As I understood your situation, you have 3 maxed out credit cards with low rates, fairly regular late payments on those cards, and a high interest car loan. Based on that information, and the information from Dave Ramsey’s teachings (and other financial professionals), it seems like the best thing to do would be to get current on your credit cards to avoid paying late fees. Then redirect that money toward paying off your other loans.
It may be best to pay off all the credit cards if possible, or it may be best to pay off one completely, cut it up, and use the money you were spending on that bill to “snowball” toward your other cards. You can also get current on your payments, then use the remaining money to start an emergency fund. There are probably several ways you can handle this effectively.
No new car. One thing I don’t think anyone can recommend is buying a new car. First, you can’t fix debt with more debt. The math doesn’t add up. Second, if you have been making frequent late payments on your credit cards, your credit scores are probably low right now, which means that buying a new car will entail another loan – probably at the same rate as your current car loan rate, or even higher! Because you still owe money on the car you would be trading in, you will just add the money you owe to the cost of your new car, making your payments much larger than they should be, and stretching them out longer than necessary.
A great opportunity for change. This tax rebate can be a real blessing for you and your family, and give you the opportunity to catch up on your late payments and avoid having to pay more of them in the future. The important thing to remember is to make positive changes and try to avoid taking on more debt. If you pay off a credit card, consider cutting it up and don’t use it again.
Should you use a debt consolidation company? This is a common question, and one you need to investigate before taking action. Many people don’t realize it, but this is something you can do on your own. Here is how to do your own debt consolidation plan.
Good luck. K., I wish you and your family the best of luck in slaying these debts.
Reader comments? If any readers have any comments about how they would do this differently, or if you have other ideas or words of encouragement, I invite you to leave them in the comments section.