Coming to terms with credit card debt
Coming to terms with credit card debt

Gasoline prices are at record highs. Housing values continue to fall, and the general economic environment feels uncertain. For consumers strapped for cash, the temptation to whip out the credit card and use it for basic living expenses is strong.

But before you take this route, think carefully. Non-secured credit card debt is expensive for several reasons. First, credit card interest payments are typically higher than debt secured by your home or even a car. Second, the interest isn't tax-deductible. And finally, and this could be the most insidious part of it all, debt can beget more debt. If you're not paying off the principal, interest payments begin to compound and, for some people, can spiral out of control.

There are plenty of good reasons to use credit cards. They're convenient, of course, and often necessary — try to rent a car or buy an airplane ticket without them. Sometimes they come with valuable benefits — extended warranty coverage or frequent flyer miles. But there's rarely a good reason to pile up credit card debt; and if you do, it's time to get yourself a plan for eliminating it.

Some debt may be unavoidable, and some levels of debt can be manageable: The "28/36” rule may provide some perspective. According to this common guideline, your housing-related costs, including mortgage debt — principal and interest — property tax and insurance, should not total more than 28 percent of your pretax household income; total debt payments (housing-related plus auto loans and credit card debt) should not be more than 36 percent of your pretax income. If you're beyond that figure, you could find yourself in financial trouble.

Here's why: Interest payments are an expense, and if you're paying 36 percent of your income on interest payments, that's more than a third of your earnings devoted to debt service. Obviously that cuts into your lifestyle, significantly. For example, if you make $50,000 per year and spend 36 percent on debt service, that amounts to an $18,000 reduction in your income. Now turn it around and instead imagine that you receive an $18,000 pay increase; that's a pretty substantial improvement in your personal financial situation. Paying credit card interest gets you nothing. In effect, you're sacrificing money you could be using for savings or improving your standard of living.

Here's another issue for those with serious credit card problems: Missing a payment can be disastrous in multiple ways. First, most credit card companies charge substantial fees for missed or late payments — meanwhile, your balance and the associated interest charges continue to climb. And second, missing payments and defaulting have dire implications for your credit rating, potentially raising the cost of credit in the future and hampering your ability to get credit at all. Credit mistakes can be long lasting and expensive.

If you have problem levels of debt, what should you do? The most extreme advice is to cut up the cards and pay them off. But I think of this as a last-ditch solution for those with serious credit problems, for people who are literally addicted to credit-based spending. Clearly, many people don't have that issue, but still find themselves with more credit card debt than they'd like. For them, this may be a better approach than going "cold turkey.”

First, you may not want to make paying off your credit cards your highest priority. Depending on your personal situation, your first priority should be contributing to your workplace retirement plan, at least up to the level of any company match. I'm referring to 401(k) plans that allow you to save with pretax dollars, help you build wealth for your retirement when you'll really need it and often offer to match some percentage of your contributions. Even if you have a lot of debt, the many advantages of 401(k) plans are simply too good to pass up, especially the company match, which is equivalent to an immediate, risk-free positive return.

Let's assume you contribute enough to your 401(k) to capture your employer's match. Now it's time to whittle away at your high-cost consumer debt. Plan your attack: Start by ensuring you're paying at least the minimum on every card each month. Then pick the cards with the highest rates and pay more than the minimum; in fact, pay as much as you can reasonably afford. Your goal is to get the balances on your cards — and, therefore, the interest payments you'll have to make — to $0.

If you own a home you can also consider establishing a home equity line of credit (HELOC), and then use that to pay off outstanding balances. You'll likely benefit from a lower rate on the HELOC than on your cards, and in most cases, HELOC interest will be tax-deductible, which also lowers your cost.

But once you've done that, it's time to start chipping away at that debt — paying not just the interest, but the principle as well.

Set up an emergency fund with three to six months' worth of living expenses. Contribute more to your retirement account, up to the legal limits. Start saving for other goals, such as owning your own home or putting your kids through college. These goals require assets. And every dollar you don't pay in interest on your debt is a potential asset for your future.

Carrie Schwab Pomerantz is Chief Strategist, Consumer Education, Charles Schwab & Co., Inc., Member SIPC. You can email Carrie at askcarrie@schwab.com.

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