Revolving Credit

 

At its essence, debt is a means to an end. You get a student loan to go to college. You take on a mortgage to buy a house. Ditto, car & boat loans. Most of this debt is secured, which means the item in question (house, car, etc) can be repossessed if the loan is not paid (with the notable exception of student loans). This setup allows the lender to charge lower rates of interest. Importantly, the loan itself is finite – meaning once you have paid it back in full, the item is yours and the debt is extinguished.

Things get trickier with debt that is not finite, that can continue to be used on an on-going basis. This “revolving” credit describes debt like credit cards and home equity lines of credit (HELOC). Use of this credit can be very useful – buying groceries, tickets, clothes and other essentials. The tricky part, as always, is paying the debt off. Because revolving credit is either unsecured (eg, no collateral to be repossessed) or relatively low on the creditor ranking (HELOCs), the interest rates for these loans is generally much higher. Research has shown that consumers buy more when using credit versus cash – even though they have to eventually still pay for the item, their behavior changes when the repayment is postponed (via credit card) versus being paid on the spot (cash).

Credit card companies have also long since learned that while they make a little bit of money on the actual purchase (the store pays them a small percentage of the sale), they really clean up when it comes to charging interest on the balance. If you do not pay off the entire balance every month, you will pay interest at a high rate. Credit card companies “helpfully” point out the “minimum” balance to be paid – this allows them to stretch out the repayments over years, providing them with hundreds or thousands of dollars of pure profit at your expense. Plus, many charge an annual fee for the pleasure!

So how best to approach this? First, revolving credit in and of itself is not bad – again, it is a means to an end. Responsible use of a credit card is perfectly ok, provided you are paying your monthly balance off in full each month! If you do have a balance, the best path forward is to stop use of your credit cards and switch to either cash or to debit cards (which pays with money from your checking account) until you have paid off your credit card balances in full. Look at each credit card where you owe money – see what the Annual Percentage Rate (APR) is. Identify the card with the largest APR (note - NOT necessarily the largest balance). For all the other cards, pay the minimum monthly payment. For the card with the largest APR, pay as much as you can each month until that balance is fully repaid. Then go to the next highest APR and do the same thing. Eventually, you will have paid off all your revolving credit and be in a better position to restart using credit cards again responsibly, this time paying off the full balance each month. Every dollar you don’t pay in interest to the credit card company is one more dollar that can go to your retirement, your children’s education or other life goals.