I’ve come across this question a few times now. I used to look at it as a purely mathematical question. So I thought that if the interest you are earning on your savings is less than the credit card debt interest, then of course, you should pay off the debt. But after having seen this fail a couple of times, it seems that this question falls more in the venue of behavioral finance.
The couple of times I saw the “pay off the debt with savings” put in to action; the person was right back in debt again within a few months. And this time the person had no savings to fall back on. So I now think it’s a smarter move to pay off the debt over time from your regular income and keep the savings as a cushion. Even if in the long run you will be paying more in interest than you theoretically could have otherwise.
Paying off the debt with the savings it turns out is like treating the symptom and not the disease. Something caused you to spend beyond your income level and rack up too much debt on the credit card. That something is not going away just because you wiped out your savings. That problem needs to be fixed, or else in a few months, you’re going to be right back in the problem.
My thinking is that this something is a misunderstanding of what lifestyle your income can afford. If you’re living paycheck to paycheck, then you’re living beyond your means. One unexpected expense and you’re in debt. And since you spend all of your money each month, you’re not going to have a way to pay that debt off, so with each new unexpected expense, your debt just grows. The solution is to readjust your expectations of what you’re income can afford so that you have some income left over at the end of every month.
So my advice to someone trying to pay off credit card debt is to take some money each month from your regular income and put it toward paying off the debt. It will be slow and painful, but that’s the point. We learn and remember better when we go through some pain to do it. Think about touching your hand to the stove. How many times did you have to do that before you realized it wasn’t a good idea?
According to research we try to avoid pain two and a half times as much as we try to seek pleasure. So the more psychological pain you can create from this situation, the more you’ll avoid it in the future. And if you go for the quick painless fix, you’re not going to be fixing the real problem. So you’ll just end up in a worse position later.
During this time you should be paying off all of your purchases each month, or just using cash. If you have multiple cards, you might be able to consolidate the debt on to one card, but I worry that this might feel too much like a quick fix. It might be a better idea to pay the minimums on all the cards, and pay more on the lowest balance card.
Most advisers will say pay more on the highest interest card. That makes sense from a numbers point of view, but we’re dealing with a psychological problem here, so the numbers don’t matter as much yet. The intent in paying off the smallest balance first is to build momentum. The smallest balance can be paid down and the account closed in the shortest time. So you see some results from your work. It turns out that seeing results from our efforts is something that makes us happy, especially when we can hit a goal, like paying off an entire credit card. It creates a positive feedback loop in the brain that reinforces the actions that lead to the positive feelings.
Then the minimum from that closed card and the excess you were paying on it can go to paying off the next smallest balance, which combines with the minimum you were already paying on that card. In this way you snowball into paying larger and larger amounts on the cards so that they get paid off faster and faster. And when you get to the big looming one at the end. The one that seemed like you could never pay it off, you’ve got the confidence and the room in the budget that you now can pay it off.
That being said, it’s also important not to completely deprive yourself while paying off the credit cards. You need to have some specific amount of money that you can “blow” each month. This acts as a kind of pressure release valve. That way you don’t feel deprived and aren’t as likely to go on a purchasing binge with the credit card. You are trying to build a new expectation for yourself on how your lifestyle and spending really should be. So you don’t want to be thinking the whole time that you hate your life because that will sabotage your efforts at paying off the cards.
You also need some amount to go into savings. No matter how small. Again we’re trying to build momentum. You want to see your savings balance increase each month, as your debt balance decreases. Then when the credit cards are all paid off, you can put all of the money that was going toward paying off the debt in to savings each month because you have now adjusted your expectations to a lifestyle that can be maintained on less than you make. And that’s an excellent position to be in because now you can handle any of those unexpected expenses from savings, and you even have some money to start investing.
Over the past few months I’ve been working on some significant changes to Dividendium. Some of these changes have been cosmetic. Some of these changes have been to the backend to add more stability and prepare for some growth. And some of these changes have been in my attitude and thinking about how I want to run this site.
Of the changes, the most obvious are the cosmetic changes, but in my opinion, the most interesting are the changes to my attitude and thinking regarding the site.
You might have already noticed, but I’ve dropped the “we-speak”. So let me be explicit, this website is a one-man shop. I’ve had a growing feeling that I was being dishonest trying to make it sound like there was a team behind it. I suppose there could be a team running it, just as any company can be run with more resources than it needs, but one of the philosophies I’ve tried to promote here in my writing is to be efficient and to keep expenses to a minimum. So the site runs on a shoestring budget, and with the ad revenue and income from the Premium Services it is actually profitable and self-sustaining.
The survey from the last post was an attempt to figure out how people were using the site and what they found valuable. My expectation was that most users were here for the data, and that the articles were just my ego stroking. And initially it seems that is what the new users do come for, but then they seem to be returning to read the articles. There were many complaints submitted that I was not adding new content often enough. So my intent is to post an article weekly by Monday. If you don’t see an update in a period of a week, call me on it and email me at contact us, anonymously or otherwise.
Stepping up the frequency of posting might seem contrary to a post I did a while back stating that I didn’t want to update too often because that would actually be a disservice to users. But it turns out that many of the users who read the articles are beginning investors, or investors who haven’t yet figured out what their strategy is. So I want to use the site as an opportunity to help these users. If you have a question or concern about investing, feel free to ask it at contact us.
Let me know if you see any bugs in the new design or if you have any complaints about it or requests for changes. I’ll be happy to address them.