Rule #4: Eliminate (and Avoid) High Interest Debt.

14 money rulesA reader asked me if I could break down my ideas into a handful of principles. After some careful thought, I came up with a list of fourteen basic “rules” that summarize my money and life philosophy. I’ll be presenting these as a weekly series.

This rule is about as subtle as a sledgehammer, of course. Many of you started visiting The Simple Dollar because you came to this realization on your own – high interest debt is a terrible idea, and even low interest debts are a terrible idea. Let’s count the ways.

Reasons to Avoid High Interest Debt

The higher the interest rate, the more money you lose.

Leave a $1,000 debt on a credit card with an 5.5% APR for a year and you lose $55 – not good. But if you bump that amount up to a level that’s typical for credit cards – say, 19.9% – and you’re up to $199 a year. Gone. Poof. Vanished.

The higher the debt level, the more money you lose.

So, you have $1,000 debt on a credit card with a 19.9% APR and you lose $199 a year. Bump that up to $5,000 and you’re losing $998 a year. Gone. Nothing in return.

You’re open to extra fees

Late payment fees, over-limit fees, annual fees, ATM fees, cash advance fees — hidden fees that drain your money. If there’s a way to ding you, credit card companies will figure out how to do it. A fee here, a fee there, and you’re suddenly watching even more money evaporate for nothing in return.

A required debt payment each month reduces your freedom.

With that $5,000 debt above, you’re paying about $100 every single month as a minimum payment. That’s $100 you could be saving for a down payment. That’s $100 you could be saving to start a business. That’s $100 you could be saving for a car. That’s $100 you could be saving towards retiring early. That’s $100 you could be saving towards a great vacation. Your freedom is gone, eaten by the debt monster.

Jigh interest debt brings other debt into your life.

You make a big commitment to getting rid of all of this debt, then start really bearing down on it. You get half of the debt gone, then all of a sudden disaster strikes. You lose your job. Your car breaks down. Your hot water heater leaks water all over the basement. Suddenly, you’re busting out the plastic again to take care of the problem – and you’re right back deep into debt. It’s like escaping from quicksand – if all of your strokes are perfect, you can pull yourself out slowly, but if even one little thing goes wrong, you’re slurped right back in.

In other words, it costs you money, costs you freedom, and puts you into a vicious cycle of even more debt.

How to Eliminate High Interest Debt

There are really two prongs to getting out of this trap. Whether you’re avoiding it entirely or you’re trying to escape from the pit of despair, there’s one big first step you must take.

Build a Small Emergency Fund

The first step is not paying off debt. Paying off debt first is like kicking to get out of quicksand without getting your arms around something safe first – you might be able to kick out, but if anything goes wrong, you’ll just be sucked in deeper.

So, no matter what state you’re in, give yourself that rock – a cash emergency fund, sitting in a savings account. It doesn’t need to be too big – $1,000 should be your big target, but just start by putting $20 a week into savings – or more if you can swing it. Instruct your bank to do this automatically. Do it right now – call up your bank and ask them to do it.

You won’t miss that $20 a week. Your life will quickly find little ways to save – you’ll eat a few less expensive meals, start carpooling with a friend, or skip a few coffee shop visits and you’re there. What happens is that over the course of three months, your savings account reaches $250. After just shy of a year, your savings account will have $1,000 in it.

If you’re already making extra payments on your debts and you don’t have an emergency fund, stop those overpayments for a while and deposit that extra amount into your savings each month until you reach that $1,000.

Leave this money alone except for an emergency. You might be tempted to spend it on something fun or to pay off a big slug of debt with it. Don’t. That money is your rock – it’ll be there for you if your car breaks down or you lose your job. You won’t be sucked back into debt by these unfortunate events – your savings will save you.

What do you do when you reach that $1,000 level? Many people keep saving. Then, once a month, they sweep anything over $1,000 back into their checking and use it to make an extra debt payment, knocking down their debt without touching their $1,000 emergency fund.

Here’s the big key: if you do face that emergency, like having your car break down or losing your job, and you tap that emergency fund, replenish the fund after the emergency. Go back to minimum payments on your debts and rebuild that fund. It’s your rock.

I’ve written a detailed guide to building your first emergency fund if you want to know more.

Make a Debt Repayment Plan

When you have that emergency fund in place, it’s time to start tackling your debts in an intelligent fashion. Make a big list of all of your debts; then, attempt to get the rate on each of those debts reduced. Give your credit card companies a call and negotiate your rate down. Contact your local credit union and see if there are any opportunities to consolidate your debt at a lower rate.

Once you’ve done these things, list all of your remaining debts in order of interest rate, with the highest rate first. Then throw everything you can at the highest interest rate debt. Your only extra payment should be towards this top debt, and it should be the biggest overpayment you can muster without tapping your emergency fund. Live lean. Sell off stuff you don’t use. Find ways to earn a few extra bucks to throw at it.

Once that first debt is gone, throw everything at the next one, then the next one, then the next one. Your extra payments will grow larger because you’ve got fewer minimum payments to make, and soon you’ll find yourself free.

I’ve written a detailed guide to building a debt repayment plan, too.

Avoiding High Interest Debt

I’m not a “no debt” absolutist. I think that home mortgages are often worthwhile for most people, and I think credit cards can be a useful tool if used carefully.

Having said that, many people do not use credit cards carefully. Instead of carefully using them as a tool during very regular purchases (like gas) and then setting the cash aside to pay the bill in full each month, they use credit cards mindlessly to buy whatever they throw in their shopping cart, not worrying too much about prices because, hey, the credit card will cover it!

Bad idea. If you have any inclination in that direction, cut up your credit cards, seriously. It’s the equivalent of swinging a chainsaw around with your eyes closed after knocking back three shots – you might luck out and wind up safe, but it’s more likely to wind up bloody and painful.

Instead, adopt a different approach. Leave your card at home most of the time. When you do use it, use it for specific purposes, like using a BP credit card and use it only at BP gas stations so you can get a nice kick back, or use the Target Visa only at Target to get 10% off your entire purchase regularly, and pay off the balance in full every time. Otherwise, leave it at home and use a debit card (one that features a Visa or MasterCard logo) for your purchases because then you’re actually accountable for every dime you spend while still enjoying the convenience of card use.

There are two big reasons for using this approach instead of going entirely down the cash road. First, it builds a positive credit rating, and a good credit rating improves your insurance rates and helps your employment opportunities. Second, using cards only in a very targeted fashion – as shown above – and paying off the bills in full each time results in some sweet cash kickbacks – 3% at least.

You’ve just got to respect the tool – and not start swinging it around like a toddler with an axe.

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  1. Josh says:

    Can you link to the other rules in this series?

  2. kev says:

    Yeah, my wife had $1800 debt on a store card at 28.8%,
    and we had a bank account with a $5000 inheritance she received sitting in it. If it was our regular money, I would have moved quickly to eliminate the debt on that card, because we’d still have more than 3k sitting there, and we were paying more interest than we were earning.

    But it was her inheritance, and she didn’t want to touch it; she thought of it as both an emergency fund and a house downpayment.

    Eventually I convinced her by showing her how much money we were hemorrhaging on this stupid store card, we paid it off along with a couple other debts, and guess what; without all those monthly minimum payments that barely covered the interest, we were able to get back up to 5k pretty quickly.

  3. Anne KD says:

    OK, I can’t help it. Let’s all hope Trent doesn’t have personal knowledge of a toddler swinging an ax!

  4. George says:

    Or a drunk swinging a chainsaw? :-)

  5. Coupled with this article is an article I wrote titled “Get Out of Debt Quick! 6 Easy Steps to Financial Freedom”. It can be read here:

    http://hundredgoals.com/2009/01/30/get-out-of-debt-quick-6-easy-steps-to-financial-freedom/

  6. Rangzy says:

    Oh, is a 19.9% APR ‘high’ for credit card? In India, the normal APR is 36%. That is when you have been paying the full bill-amount every month without fail. You make one late payment, it shoots up more than 40%.

    And, what is the interest % for education loans in the USA? In India its around 13% p.a, cumulative.

  7. Curt says:

    Great advice. Thanks for sharing.

  8. Kristin says:

    Serious question here:

    I have been paying off my debt like a pro (law school and loss of a job caught up with me). I have virtually no savings bc I use all of my extra money to pay off debt. I just found out that my dad has cancer and will probably need a lot of financial help the next couple of months (hopefully). I agreed to pay his insurance for the next 3 months (the length of time for Family medical Leave Act) and I sent him some money to cover his rent this month. My dad has no money. I do not know what to do. Do I start an emergency fund now? Do I just start paying minimums on my CCs? Do I just give him all of my extra money?

    Any advice is appreciated.

  9. Kristin says:

    As an addendum I stopped charging on CCs approximately a year ago and I refuse to ever get in this situation again. I still have my credit cards but I don’t use them. As they get paid off, they get shredded.

  10. kat says:

    Kristin,
    If your dad is over 55 there are many agencies you can contact for help for him. Please check into what is available for your area, also contact his hospital about help. Many hospitals have a social service person to direct patients and families to the correct agencies for help with care, bills and living expenses no matter what the age of the patient.

  11. Kristen (#6)–This is just one mans opinion…I’d put your debt elimination plan on hold until your Dad is in the clear. Your fathers time is now, your debt paydown can wait.

    What you’ve done thus far is very noble and shows that your heart and your head are in the right place. It might not be a bad idea to get some counseling from someone, maybe a close friend, financial advisor or see what is available at your house of worship.

    I’ve been where you’re at right now, and this is one of those times when plans, even good ones, are put on hold.

  12. Kristin says:

    Kat and Kevin:

    Thanks. My dad is in contact with a social worker at a hospital in MS where he lives. I live in LA which further complicates matters. He is 58 years old. From my understanding, SS disability requires him to be disabled for at lest 6 months before he can get any aid. I am hoping that some agency can come through to help him out until that time. My main concern is that the money I do have to give him after all of my bills are paid isn’t enough to cover him. I truly appreciate everyone’s responses.

  13. Kristin, some churches have funds for people in this situation. Even if he isn’t a member, it might be worth checking to see if they might help. Also check to see if they can provide direct help in the form of visitors who might help with shopping, errands, laundry, or just spending time. Cancer can be just as debilitating for the mind as for the body, and depression is common.

    Check with the community he lives in to see if any services are provided, or if someone can point you in the right direction. Let your employer know about your $ situation and see what suggestions they can offer.

    Have you spoken with his landlord to see if he can get a temporary reduction in his rent? If your dad has been a good tenant he may get some flexibility.

    This is one of those times when you try anything!

  14. CL says:

    I have not had good responses from my credit card company when I asked for a lower interest rate.

    Perhaps I’m using the wrong “sales pitch” on them?

    Has anyone had any luck lowering rates on current cards (with balances)? If so, can you tell me what you said?

  15. kitty says:

    Kristin(comment #6): I assume your dad is insured, and you worry about co-insurance, right? If so, you may check out the following link: http://www.cancercare.org/pdf/fact_sheets/fs_financial_en.pdf

    It contains the list of organizations that help people with co-insurance. Different organizations have different rules and different income limits. As a rule, their income limits are considerably higher than medicaid. Maybe about 50K a year or something like it – you have to call to find out. If one of the listed organizations doesn’t work out for you, check another one. The two that definitely help are healthwell and patientaccessnetwork, but you should check out all of them.

  16. kitty says:

    One other thing – American Cancer Society may have some info as well, so you can find your local chapter and call. They also sometimes help with transportation: when my mom was having her chemo treatment a woman came up to her, introduced herself, said she was with ACS and said that if my mother ever needs a ride to/from treatment, they do it.

  17. Helix says:

    CL -

    If your credit rating is very poor, you might not have much luck. If it’s good, I’d look around for cards offering 0% balance transfers. When you call the companies, tell them if they don’t lower your rate you’re going to have to look into moving it to a 0% offer and close your account.

    You could also go to a credit union and see what they offer in the way of personal loans.

    Oh, and don’t get mad; that doesn’t work. If they say no, ask to speak with a supervisor. If the supervisor says no, thank them for their time and try to find somewhere else to move the debt.

  18. The emergency fund–I tend to think that’s the key to the whole strategy. There’s no point paying down your credit cards if you’ll have to charge them up as soon as a crisis hits, so the emergency fund is really foundational.

    It would be worth doing anything you can to get that started with a chunk of money. $20/wk is the way to go failing all else, and it’s certainly the long term strategy, but at least psychologically it’s good if you have a pile right way. Try selling some of your stuff, either thru garage sales, ebay or Craigslist. Sell off stocks your grandparents gave you, a little used jewelry or silver collection, unused exercise equipment or anything that you don’t truly need.

    If you could sell off enough to raise $1000 within the first few weeks, then add $20 or what ever each week you’d be well on your way, and have something to build on. That would be a huge emotional lift. Then work on the credit cards.

  19. Lois says:

    Trent,
    I have been wondering about just this thing. Perfect timing for me. Thanks for the information.
    I just want to verify something in the article. Did you mean that using a bank debit card with a credit card logo (using as a credit card) will build up your credit? My credit hasn’t been very good, but I haven’t used any credit cards for a while. I use my bank card for almost everything now. The site really is very useful, and inspiring to those of use trying to move forward.
    A PS to Kristin
    Many of us are, or have been, the same boat. My daughter had cancer while pregnant a few years ago, and she lost just about everything. We helped all we could, and it really put us in a bad spot, too (but she and the baby are healthy now). She is still struggling to get out from under all those bills, as even with insurance it is very expensive. Sometimes you just do the best you can, and keep on going…

  20. Debt must be seen as a “negative” investment. Instead of earning interest on your money, you are paying interest to someone else.

    Short-term, high interest debt, such as credit cards, is usually a big mistake. Getting into debt to fund your everyday spending is just crazy. It leads you to spend more than you can, and it gets you into a spiral.

    Of course, sometimes, carefully planned long-term debt such as a mortgage can and does make sense. It is a very useful tool. But still, needs to be used very carefully. Many people misuse this resource by getting too much in (i.e. buy houses they cannot afford or without a down payment).

  21. Sarah says:

    I have to admit we are pretty lucky our health care system in Canada is so good because I have no idea what you guys are talking about when you talk of medical bills and costing all your money.I really needed to hear this to remind myself how grateful I am to not worry about being sick and paying down debt…Whew!

  22. Great advice, Trent. I just got laid off and am actively looking for unemployment with credit cards looming overhead. I’m delaying calling them to inform them that I’m unemployed until I figure out which ones I’m going to keep (obviously the lower APR ones – but I’m so busy looking for jobs I haven’t had time to sort this out). I’ve heard of people calling cc companies and getting 6-months of interest payments waived. Do you think this is feasible or should I ask for something more? Thanks!

  23. Lenore says:

    KRISTEN–I used to work at an agency that helped AIDS patients. We advised those overwhelmed by debt to pay as little as $5 a month to each medical creditor. The slightest effort toward settling a balance may forestall collection and keep a patient eligible for services. Housing, food and utility bills are seldom so flexible.

    My father was recently very ill, and I learned some useful tips on negotiating the often-baffling healthcare system. Hospitals generally have a Social Work department to assist patients with financial or personal support needs, but you may have to specifically ask for it. The doctor who coordinates a patient’s care inside the hospital is called a Hospitalist, and communication with that office can be crucial. Ask lots of questions and encourage your father to do the same. Keep a notebook handy for jotting down all the information you can in one place. If there are problems with quality of care, complain all the way up the chain of command, consulting the Administration if necessary.

    I’m on Social Security Disability for bipolar disorder, and it is NOT an easy road to get accepted. Even the worst-off AIDS patients were usually denied on their first application, so assume that your father will be too. I have never seen anyone make it through without a lawyer, so get one you don’t have to pay unless and until that rainbow check arrives. It can take several months to a few years to negotiate the process, but the good news is that you’re paid retroactively to the date you filled out your initial application.

    Hope some of this helps and that your father soon regains his health. Remember to take care of yourself too. Hugs from Illinois!!!

  24. GroundPig says:

    Great article. I couldn’t agree more. One of my friends thinks that so long as he pays the minimum amount for his credit card every month, his finances could last forever. He mentioned this to me 7 years ago when we were still in college. It was astonishing. His minimum payment at the time was $130 already, and he was just a student with no job. I talked with him last week and he’s still in the same rut. His habits haven’t changed much even though he has a pretty good high income job now. The key point I take out of your article is that it’s important to have a plan to repay the debt. The income doesn’t really matter that much if your spending habit won’t change.

  25. Mike says:

    I agree on the part to set money on the debt that sucks off high interest payments off you first. Stalls interest from rolling on by the months.

  26. kitty says:

    Kevin #16 “The emergency fund–I tend to think that’s the key to the whole strategy. There’s no point paying down your credit cards if you’ll have to charge them up as soon as a crisis hits, so the emergency fund is really foundational. ”

    There is a point — saved money on interest that occurs between now and your emergency. Let’s say you have $1000 in a bank and $1000 in debt. Let’s say you have 12% yearly interest on your debt and 0% on your saving account in a bank — normally you’d get some small percentage on your bank account but 12% is a very conservative estimate for your credit card interest too. To keep things simple we’ll ignore compounding or everage daily balance, ignore whatever money you save every month or your minimum payments.

    Case 1: you use your $1000 to pay off your debt. Net result $0 in the bank and $0 in debt. The “money” portion of your net worth is 0.

    Case 2: you keep your debt and your $1000 as an emergency fund i.e. you owe $1000, so your net worth is still 0.

    Let’s say an emergency happens exactly one month from now and it costs you exactly $1000.
    Case 1: Ignoring whatever amount you could’ve saved for simplicity, you still have nothing in a bank and you don’t owe any money. You borrow $1000. Net result: you owe $1000 and have nothing in a bank.
    Net worth: $-1000.

    Case 2: During this month, your debt has grown by 1% more than your savings. So now you owe $1010. You still have $1000 in a bank as an emergency fund. So you use this $1000 to pay for your emergency and you feel good about yourself. But… You still owe $1010. Net worth: $-1010. I.e. you are $10 worth off or shall I say you paid extra $10 for “feeling good about yourself”.

    This may not sound like much, but if your interest had been higher or the amount larger or you had more than one month between now and emergency, the difference could be more dramatic.

    Now, this was a very simple case. In a real life situation, the extra interest would’ve been offset by your minimum payment in case 2. But then in a real life situation, you could’ve saved the money that go towards minimum payment in case 1. In a real life situation, you would’ve used high yield savings, but than the interest on your debt could’ve been much higher than 12%. Plus I didn’t even consider compounding.

    I think one of the reasons people get in debt is that they cannot forget about “feeling good” and concentrate on the bottom line. If you change your mode of thinking, you may be able to avoid debt or get out of each much sooner.

  27. onaclov says:

    Trent, I don’t want to sound picky, but I was having a hard time finding the first post in this series, I finally realized I could click on the keyword and it would bring me here. It might be easier for people to follow this “series” if you cross link with the first post…. Just a suggestion..

  28. Ami says:

    Love the Princess Bride references!

  29. Bobby says:

    It’s not for everybody, but people carrying more than $10,000 in consumer debt can really benefit from a debt settlement program. For some people, it’s better to take a small hit to your credit and wipe out the debt as quickly as possible, than to barely make minimum payments for years and years.

  30. pia says:

    i’m trying to get myself out of a $17,000 credit card debt. i’m $2000 in to removing it, and i’m stoked.

    but according to your advice, i should stash $1k aside first as an emergency fund.

    the only problem is, i’ll somehow find a way to justify a new dress as an ‘emergency’ etc. you get my drift. any advice in terms of setting criteria for how the ‘emergency funds’ can be spent? is there a golden rule that can help me discipline my spending?

  31. bargainph says:

    @onaclov: Trent’s money rules can be seen on the sidebar. That’s how I go through the money rules.

  32. steve says:

    What I do is set aside cash for my purchase first if it’s a regular purchase like gas. In other words, for gas I take 40 dollars out per month and put it in an envelope marked “gas”. Then, if I want to use a credit card to make the purchase itself, I take the cash I’ve set aside and put it in an envelope marked “Visa”.

    This is better than making the purchase with a credit card first, then scrambling for the money to pay for it.

  33. james says:

    Well i think debt problem is a common sickness, but if your carrying more then $10,000 on your credit card debt, your best bit is to settle with the bank. if your looking to safe your credit rating, news flash, if your struggling to your debt you dont have credit any more all you have is debt.

  34. Greg says:

    So, let me get this straight, you want us to hold off paying a debt by storing money, all the while the interest that we would have otherwise paid off continues to eat away at our bank accounts? I agree people should save money up, and decrease their spending, but wouldn’t it be best if they use that saved money to lower their debt instead of saving it. If a problem does arise, you can take out that same amount you would have saved up otherwise. But you would also have that extra money you saved by having a lower debt because you spent your excess money on lowering your debt instead of saving it as you suggest. Now i am no economist, although i consider that a career possibility, but based on common sense your idea of saving money instead of paying off debt seems ridiculous. It would make sense if you had to take out a higher interest rate to get another loan. But that probably wouldn’t happen considering you have been paying off the loan better then you would have otherwise by saving money because you were using the money to pay off the loan, and therefore the credit card company would have no reason to make your interest rate higher then you got the first time. Then there is the obvious possibility that you dont have a problem, and you definitely saved money by using your saved money to pay off the loan instead of saving it. Then again, i’m just a kid, thus i hope for your sake i’m wrong. If i am, i would appreciate a response explaining why saving would be more beneficial then paying off the debt. Obviously not anything like, you could try your hand in the stock market and make over 20% of your money back in that same time because that just isn’t something you can assume. thanks.

  35. Dale says:

    I hopoe I’m not butting in, but remember, the savings is in case of emergency. The saved money should be for a limited amount only, not as an on going savings to just keep in the bank no matter what else might happen. And its not intended that you keep adding thousands after thousands to that savings account while you are in debt.

    Suppose you have sickness or injury or job loss for 90 days and that for that amount of time you have absolutely no income. By spending your savings during that time, and for that purpose, you can continue making payments instead of missimg payments, having late fees added and interest rate increases.

    Add up your total expenses for one month, including payments, utilities, car expenses, insurance and everything else you spend, and then see if you think $1,000.00 is too much of an emergency fund, or if you think $1,000.00 is enough.

    The savings is a wise safety net against loosing more in fees because of an emergency, than you might gain in interest saved.

    Once you have an adequate emergency savings fund, then maks payments in as high an amount as is reasonable to you. After the debt is paid off is the time to keep adding thousands and more thousands to the savings.

    The ultimate goal is to make the debt temporary and eventually zero and to make the savings permanent and as high as is reasonable.

    take care

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