Prepaying to Reduce Loans and Credit Card Debt Isn't Always the Best Choice

Some types of loans penalize the debtor for prepaying, or paying extra, on the balance. Thankfully most credit cards do not. Prepayment is easy; simply include additional money with your regular payment. There's no math involved. Any amount above the minimum payment due is automatically applied to reducing your principal. Each extra dollar you can afford to send with your monthly payment goes a long way in helping to reduce your balance. The key phrase here is "pay what you can afford."

Think of it this way: Money left in a traditional savings account will earn in the neighborhood of three percent interest annually. Additional dollars paid towards credit cards are money for which the creditor may no longer charge interest. Since a dollar owed to a credit card eventually will cost you a higher percentage rate, say five percent, ten percent, or more per year, you ultimately get a better overall return by paying down your debt.

With that in mind, it's up to you whether any money you have in savings would be better spent in reducing your credit card balance. Some people prefer to have a cushion in the bank for a rainy day. Most financial experts agree that using all of your savings to pay down credit cards, while a good use of the money, may leave you feeling insecure. The problem is that when savings are used, very few debtors continue to save regularly to rebuild it. If you're sure you can continue to save after paying off debt with your savings, then by all means do it. If you're hesitant, you might consider using some savings and keeping some.

There is an alternative to using savings for debt prepayment: find money already hiding in your household budget. While you're in a financial mindset, it's a good time to analyze your monthly spending. Helpful information on setting up a budget can be found at your library or on the Internet.

Do your best to reduce spending. For instance: find cheaper car insurance, drop the health club membership you never use, and eat out less often. You'll be surprised how much you'll save by simply cutting out a few non-essentials.

If you're in an especially thrifty mood, a lot of information is available on finding ways to save money that you've never considered. Using only a few money-saving tips will free even more cash for debt reduction.

Be careful, though. The last thing you want is to begin overspending on debt reduction by paying down too much debt and taking money away from things you really need. Don't neglect other financial areas. You must be certain that you can afford to spend extra on debt reduction. Start slowly. You'll find the amount that suits your budget.