A financial disaster has played out at the worst time, and now your card debt has become an emergency. What are your options?
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A life emergency can turn into a credit catastrophe, even if you’re responsible managing your finances.
It’s easy to believe credit card debt is just part of life when you have a good job and a steady paycheck. Perhaps you make the minimum payment or slightly more each month without worrying too much about your balance or debt. You’re keeping up with your bills, so you assume everything is going fine.
But disaster can strike at the worst possible time. Maybe you lose your job, face a loss in pay or wind up covering a pricey home or auto repair bill. Your credit card balance begins spiraling out of control and your minimum monthly payment is now becoming out of reach.
You no longer have the privilege (or the cash) to ignore your debt and coast through life as you once did. Your debt has become an emergency – one that must be handled before it gets worse.
How to deal with emergency credit card debt
Credit card debt: An emergency affair
Rose Jones of Wooster, Ohio, encountered a card debt emergency after losing her job in the financial crisis of 2008. Jones, now 61, had racked up approximately $4,000 in credit card debt prior to the job loss.
Credit card bills and medical debt plagued Jones’ finances during the three years she was unemployed. Collection agencies sent her letters and credit card companies contacted her several times per week, she says. Eventually, Jones settled with her debtors, using her small nest egg to pay off a portion of her credit card debt with the agreement her creditors would discharge the rest.
Jones isn’t the only person who has dealt with problematic credit card debt. According to Federal Reserve data, Americans’ revolving debt rose to $1.037 trillion in October 2018. On an individual level, the average adult with a credit card carries $5,839 in debt and the percentage of U.S. households with revolving debt that isn’t paid off each month is currently at 38 percent.
While many of us manage secured debts like home loans and auto loans just fine, credit card debt can be especially nefarious due to the high interest rates consumers pay. You may pay around 4.89 percent on a 30-year mortgage at today’s rates, but the average interest rate on credit cards is currently more than 17 percent.
If you owed the average balance of $5,839 and made a $141.11 minimum payment each month (using the typical 1 percent plus interest formula for minimum payments), you would spend almost 20 years paying off your balance and pay a total of $7,372.08 in the process.
In other words, you’ll pay over $1,500 to service your credit card debt. Ouch.
See related: Should you use a credit card as your emergency fund?
Should you tap into your emergency savings?
The simple answer to avoiding a debt catastrophe is never carrying a balance and using credit responsibly. However, Ryan Inman, a fee-only financial planner for physicians and host of the Financial Residency podcast, says it’s not that easy – credit card debt has a tendency to creep up when you least expect it.
“Life happens, and due to a medical emergency, an unexpected change in income or other unforeseen circumstances, it’s not always as easy as we wish,” he says.
If your credit card debt has become a problem, you have several potential solutions to consider, including tapping into emergency savings like Jones did. Most financial experts suggest keeping three to six months of expenses in an emergency fund, which could be used to pay off credit card debt when it becomes an issue.
While this strategy can work if you have plenty of reserves, Inman says to think long and hard before you dip into a fund that is meant to protect you from financial mayhem.
“If you deplete your emergency savings without having an ability to build it back up, then it can be difficult to get out of debt as other unexpected expenses arise,” he says.
Inman also cautions against borrowing against your 401(k) or other retirement assets. You could stunt the growth of your investments, and you may also have to pay taxes and penalties to access these funds early.
A balance transfer or a loan can lower interest payments
How can you knock out high-interest debt without depleting your savings or retirement fund? A loan or a balance transfer credit card could provide the lifeline you need.
Personal loans and balance transfer cards often come with interest rates lower than the average credit card. By consolidating your card debt with a new loan or balance transfer, you could save money on interest each month and have more of your payments go to the principal balance.
Many balance transfer cards offer introductory 0 percent APRs for an extended period of time. For example, the Citi Simplicity Card currently allows you to pay off a balance transfer at no interest for 21 months (variable APR is 16.99 to 26.99 percent thereafter). The Discover it® Balance Transfer card and the Citi Double Cash Card each offer 18-month no-interest periods for balance transfers. After the intro period, the Discover it Balance Transfer offers a 14.24% to 25.24% percent variable APR, and the Citi Double Cash card a 15.74 to 25.74 percent variable APR, both slightly lower than the average credit card. Cards that allow balance transfers generally charge a fee of 3-5 percent to do so, but there are some exceptions, such as the Capital One QuicksilverOne Cash Rewards Credit Card and the PenFed Promise Visa.
“If you are sure you can pay off the debt within the 0 percent introductory rate period, it could be well worth it to make the transfer,” says personal finance expert Farnoosh Torabi.
Imagine once again you carry the average $5,839 in credit card debt and transfer that debt to a card that offers a 0 percent APR for 15 months. If you were able to pay around $389 per month for the full 15-month stretch, you could become entirely debt-free by the end of the offer without a single dime going toward interest.
If you have too much debt or can’t pay enough each month to pay down your debt within a year or two, you may need to consider other options.
“If you need more time, consider a personal loan with a smaller interest rate than what you’re currently exposed to on your credit card,” says Torabi.
Personal loans don’t offer the enticing 0 percent interest offers balance transfer cards do. However, they do offer fixed interest rates that can be as low as 4.99 percent, depending on your creditworthiness, and they typically have a set repayment schedule and monthly payment. This trifecta of benefits could make it easier to budget for your monthly payment while knowing exactly when you’ll be debt free.
You could also consider a debt management plan through a credit counseling agency, or settling your debt for less than what you owe like Jones did when she lost her job. However, debt settlement is bad for your credit, and you may have to pay taxes on the canceled debt. Meanwhile, a debt management plan doesn’t directly affect your credit score, but it could still be a red flag for prospective lenders, even though you’ll eventually pay off all of what you owe.
See related: What to do when your balance transfer is denied
How will your credit be affected?
No matter which strategy you choose to escape the trap of high interest debt, you should always care about your credit score. Reducing credit card debt is a great way to improve it.
If you have savings you can use to pay off your card debt, for example, you can expect your score to rise. This is because credit utilization (the amounts you owe relative to your credit limits) is the second most important factor affecting your FICO score. The less you owe in relation to your credit limits, the less potential risk you pose to creditors, and the higher your score will be.
If you do a balance transfer, on the other hand, it could also help your score provided you begin paying your debt off faster, says Torabi. Your credit utilization ratio would steadily shrink as you pay down the balance. You’d also have more overall available credit due to the new card’s limit being added to your accounts.
But a balance transfer can also hurt your score, at least temporarily. When you apply for a new card, it results in a hard inquiry, which usually lowers your score by a few points. You may also see a brief score drop because it’s a new account, and also because the individual utilization on the new card might be high at first, depending on its credit limit.
Consolidating card debt with a personal loan could also improve your credit score because installment loans don’t carry the same weight as revolving debt under the credit utilization scoring factor. Plus, a personal loan will help your credit mix, which is another credit scoring component that shows lenders how you handle multiple types of credit arrangements.
If you decide on debt settlement, it will damage your credit score for a while. According to FICO, settling a debt for less than what you owe can cost you anywhere from 45 to 125 credit score points. Additionally, it will stay on your credit report for up to seven years, though the negative impact lessens over time.
However, that doesn’t mean debt settlement should be off the table if you feel you have no good options available. While Jones says settling her credit card debt was stressful, she is still glad she went through with it.
“The weight of carrying so much debt can be devastating,” she said.
Pay off debt and avoid it in the future
When it comes to credit card debt, an ounce of prevention is worth a pound of cure. If you can avoid carrying a balance, you will never have to worry about interest charges or how they affect your bottom line. Jones says she now carries one credit card and only charges purchases she can afford to pay off within 30 days.
But, Luskin says there’s more to the equation than just avoiding credit cards or making sure you never carry a balance. You also need to track your spending to see where your money is going and take the time to build up an emergency fund.
“When you track your spending, you’ll save money,” says Luskin.
When you are closely monitoring your spending, you have no choice but to face your decisions – good or bad. And when you’re accustomed to facing those choices on a regular basis instead of sweeping them under the rug, it’s easier to build emergency savings that can help you avoid debt in the future.
If you’re dealing with the consequences of too much debt now, take steps to pay it off or consolidate it at a lower interest rate. Doing so will help you avoid throwing more of your money away in interest payments while also buying you peace of mind.
But, don’t forget to take a close look at yourself and your spending so you never find yourself in the same place again.