Using your budget to strategically manage debt.
A solid budget structure makes it easy to control debt. Most debts are housed with your other fixed expenses – like your mortgage or auto loan are installment debts with fixed payments.
But credit card debt can be a little tricky to house. Credit cards are revolving debt. This means your bill grows as your balances go up. But if you have zero balance, then that bill disappears completely.
If you pay off your debts in-full each month, then credit card debt gets counted as a flexible expense. But if you carry balances over each month, then you may be better off making credit card debt payments as a fixed expense. This means you have to consider your budget as a whole to see how much you can afford to pay.
First, see how much you can afford to pay each month. You evaluate your free cash flow, to maximize the amount of money you have for debt repayment. Then you set this amount as a fixed expense in your budget. The funds are used to pay off one credit card debt at a time, starting with the card that has the highest APR.
So, if you have five credit cards to pay off, you make minimum payments on all four. Then use the rest of your funds to make the biggest payment possible on the debt with the highest APR. Once that debt is gone, you move on to the next. And you continue to pay each debt down one at a time.
If you don’t have much free cash to start with, knock out your debts starting with the lowest balance. Each debt you knock out frees up more cash to focus on the next. In normal circumstances, credit card debt payments should take up to no more than ten percent of your income.
And remember, if you’re having trouble making debt payments fit in your budget, Consolidated Credit is here to help.
How you treat credit card debt depends on your current situation.
As we explain in the video, most debts don’t require extra effort to manage. For the most part loans are fixed expenses in your budget. You always know what to expect and, at most, payments change annually. For instance, your mortgage may change if your property taxes increase or decrease in a given year.
By contrast, credit card debt doesn’t always count as a fixed expense. If you pay off all charges made in a month at the end of each billing cycle, it’s a flexible expense. One month you may pay $50 while the next month you may pay $150 if you make more charges.
On the other hand, if you have excess credit card debt you need to pay off then it’s usually best to switch your strategy. You make credit card payments a fixed expense in your budget. You see how much you can afford to pay each month, then set that as a fixed item in your budget. While your minimum payments may only total $350, you set $700 in your budget for credit card debt repayment if that’s the money you have available.
Roll up or roll down?
There are two basic methods of debt reduction you can use when you have excess debt. Both use the fixed payment strategy described in the video and above. They differ based on which debt you start repaying first.
- The roll down method starts with the debt that has the highest APR – this is also called the avalanche method
- By contrast, the roll up method starts with the debt that has the lowest balance – this is also called the snowball method
When roll down / avalanche debt reduction is best
If you have a large volume of free cash flow to allocate for debt repayment, it’s usually best to start with the debt that has the highest APR. You pay off this debt first because it costs slightly more each month than debts with lower APR.
For example, if you have two $500 debts on credit cards with 15% APR and 20% APR respectively:
- At the end of the first billing cycle the debt at 15% APR accrues $6.25 in interest charges.
- Meanwhile at 20% APR the debt accrues $8.33 in interest charges
That may not seem like much, but a few dollars each month can really add up. If you have sizeable debt to repay, it can equal out to hundreds or thousands of dollars.
This means eliminating the high interest rate debts first is the most cost efficient method. The trouble with this method is that your highest APR debts may also be your biggest debts. If you to spend months or years eliminating that one debt, it can be difficult to stay motivated.
Roll up / snowball is all about progress
If you have (1) a large volume of debt or (2) limited cash flow available, this method often works better. Motivation is essential in debt elimination because without it, you stop focusing on repayment. You also start charging again.
The roll up (snowball) method works because it gives you motivation by hitting milestones along the way. You eliminate small debts one at a time, each one giving you motivation to eliminate the next.
At the same time, snowball also allows you to build momentum. As you zero out each debt, you roll up more cash to use on the next one. It’s like a rolling a snowball – it picks up more snow as it rolls and gains momentum. You pick up speed and stay engaged, so you can knock out your debts as quickly as possible.