Understanding Credit and Getting Out of Debt

Credit is a blessing and a curse. Used appropriately, credit can allow us to purchase things like a home and car. However, misunderstanding or abusing credit is dangerous. A large part of staying out of debt is viewing credit appropriately. While working as a customer service representative for a bank that issued credit cards to small business owners, I found that even many entrepreneurs, whom you would expect to be financially savvy, have a very unhealthy view of credit. One individual in particular, who had been late on payments several months in a row, called to complain that we had not made all his credit available for use yet. This was a common practice the bank used for customers with poor payment history. For example, if the customer paid $500 the bank would wait until the payment cleared before releasing that $500 of credit back to the individual for use again (just in case the payment didn't come through). He accused us of "stealing his money" because he viewed his line of credit as though it were cash in the bank. This is a very warped view indeed. Nonetheless, too many people equate credit to cash as though it were money they had already earned. Instead you should view a line of credit (like a credit card) as little more than potential debt.

So if you've already fallen into the debt trap, how do you dig yourself out again? Start by setting up a budget that works for you to keep from going further and further into debt. Next, figure out where you pay the highest interest rate (probably a credit card) and put extra money toward that until it is paid off then move on to the second highest and continue until you are eventually debt-free. However, do not ignore your savings while doing this. It is important to have savings you can readily access in case of an emergency (anything from vehicle or home repair to an unexpected period of unemployment).

I mentioned paying extra money toward your debts. This is a very important point. Don't get stuck only paying only the minimum due; it's far too expensive. For example, if you have a $3000 credit card balance with a 15 percent annual percentage rate (APR) for interest and only make the minimum payments (4%) each month, even if you don't charge anything to that card ever again, it will take you 87 months to pay off the debt and you will have paid $1209 in interest charges. That's just over 40% of the principal in interest! Obviously the situation is much worse if you continue to charge to the account, which is a more likely scenario.

You need to get ahead of the game. In order to get out of debt and save paying high interest charges you need to budget more than the minimum monthly payments. In our previous example if you were to pay 10% of the total principal, that's $300, a month you would pay off the debt in 11 months and pay $225 in interest costs. That's a savings of almost $1,000. There are many resources such as credit and interest calculators online that can help you determine what amount best fits your budget. You can check some out at cardtrak.com/calculators or just do a Google search for interest calculators.

Once your highest interest debt is paid off take all the money you were paying toward that debt (since you have already budgeted living without it) and add it toward your next highest interest accruing debt and so on until you are eventually debt-free.