Blog | Personal Finance

Avoiding Bad Debt

Two simple steps to help you stay out of consumer credit card debt

For most American families, the biggest barrier to financial freedom is the persistent rise of bad debt. The Federal Reserve Bank of New York's Center for Microeconomic Data, recently released its Quarterly Report on Household Debt and Credit. This report revealed that household debt increased by $35 billion during the second quarter of 2016. Credit card debt alone rose by $17 billion.

This debt is overwhelming many middle class families, and it's easy to see why. Credit card debt is one of the easiest traps to fall into. Applying for a new credit card takes little time, and in the moment, using a card to make purchases has little immediate consequence. It's not until you have a balance in your account at the end of the month that things start to go sideways.

The Urban Institute, partnering with the Arizona Federal Credit Union, recently released a study based on 14,000 credit card users. They created two "rules of thumb" to guide credit card usage, and help users avoid bad debt. These two rules are listed below, along with some of my own tips to watch your credit card habits and avoid falling into bad debt.

Don't swipe the small stuff

The Urban Institute writes: "Don't swipe the small stuff. Use cash when it's under $20."

It's amazing how quickly all our small purchases add up. Things like your daily coffee or a snack from the corner market cost you more than you realize. It's easy to justify all those small purchase at the time. Only $3 for a plastic water bottle? No problem! But at the end of the month, those purchases add up.

When you use physical paper money, it can help you be more aware of how much you're dolling out. It might even cause you to reconsider those small purchases when you find yourself running out of cash quickly.

So in the future, when purchasing things under $20, try using cash instead and see how your spending habits change.

Credit keeps charging

The next rule of thumb says: "Credit keeps charging. It adds approximately 20 percent to the total."

Credit card interest is always compounding, and over time it quickly adds up.

Let's say you have $100 debt and it accrues 20% interest every month. In your first month, you will be charged $20, which gets added to your original debt. The next month, you are again charged 20%, which now comes out to $24. So after only two months your debt has gone from $100 to $144.

This compounding interest works against you as you try to pay off your credit card debt. Some credit card companies even compound at a daily rate, not monthly, so being aware of how your interest grows can help you stay out of trouble.

Pay your balance

It might seem like a no brainer, but to avoid severe credit card debt, pay off your balance at the end of each month. Debt grows when you start each month owing on payments and collecting interest on debt from the month before. As they compound, you can quickly find yourself in a hole you can't get out of.

Paying off this debt is not impossible. (You can read Robert's article here about 6 ways to erase debt.) But the best defense is a good offense, so head off trouble early to avoid bad debt where you can.

In Conclusion

Avoid using your credit cards on typical daily purchases, under $20, use paper money instead. This keeps you mindful of the amount you have, have spent, and have left to spend. The more mindful you are about how much you are spending on a consistent basis, the more you can avoid "over-spending".

The interest on your credit card balances continues to grow the higher your balance on the card. 18% of $50 isn't that much money, but when $50 becomes $5,000 you're looking at a MUCH higher amount of interest added to your balance. Pay off your balance as quickly as you can and don't let it grow again. Once you've gotten it paid off, be sure to pay off anything you add to the card as soon as you add it to your card. Obviously having "good credit", means you're using credit. That doesn't mean you let your debt-to-income ratio grow and grow and grow.