With the average credit card interest rate now over 24%, borrowers pay nearly a quarter to finance every dollar they charge. Thanks to the power of compounding, however, that quarter doesn’t remain a quarter for very long.
The reason that revolving debt is so dangerous is that this month’s interest gets tacked onto last month’s balance, the sum of which then starts accruing interest all over again.
According to a new GOBankingRates study of more than 1,000 adults, nearly half the country is all too familiar with this cycle — because 47% of Americans have credit card debt of their own. Let’s explore some of the reasons for this, and why it can be detrimental to your financial health.
The Vicious Cycle of Inflation-Fueled Charging
The combination of compound interest and variable rates has always made credit card borrowing a form of toxic debt — but in today’s unforgiving environment, plastic is as bad for consumers as it is for the ocean.
“Rising interest rates have a direct effect on credit cards,” said Kevin Miller, a financial coach at Financial Finesse. “Their rates tend to go up at least as quickly as rates are raised by the Fed or in the marketplace. With inflation driving more to use credit, it is a vicious cycle for credit card users. Their balance goes up because their paycheck doesn’t go as far. Then, the interest rate goes up on the credit card balance, making the debt that much more difficult to pay off, which, in turn, spreads their paycheck even more thinly.”
The results have been predictable.
“Credit card debt rose to a record high last year,” said Richard Barrington, a financial analyst for Credit Sesame. “For people carrying credit card balances, the interest owed is growing faster than they have ever experienced previously.”
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High-Interest Borrowing Leads to More High-Interest Borrowing
Finance charges over 20% might be the most immediate incentive to pay down your cards, but your credit score should motivate you too, because the more credit you use, the lower your score falls.
“This number can be crucial if you ever need to borrow money for a car loan or a mortgage,” said Sam Weisfeld, managing editor at Finimpact. “If you can secure a loan at all, having a low credit score may result in higher interest rates. Even other elements of your life, like the insurance premiums you’ll pay, whether a landlord will let you rent an apartment, and even whether an employer will hire you, can be impacted by your credit score.”
In short, high-interest credit card debt sinks your score, which means that when you have to borrow money in the future, you can do so only by taking more high-interest debt.
The Debt Reduction Sequence: Save First, Invest After
Since credit card debt is more dangerous today than it has been in decades, you might be tempted to throw every dollar you have at your statement balance. The urgency is understandable, but you must build short-term savings while simultaneously paying down your debt, even if it slows the process down.
The reason is that without cash savings, you’ll be forced to do even more damage to your cards when unexpected expenses arise. What can wait, however, is long-term investing.
“Save a three- to six-month emergency fund first,” said Garett Polanco, CIO of Independent Equity. “Then consider pausing non-essential saving and investing to tackle high-interest debt.”
Balance Transfers — Use a Credit Card To Beat Your Credit Cards
If you’re struggling with credit card debt, another credit card is probably the last thing you think you need. But if a fresh account lets you park your debt for a year or more without incurring any new finance charges, it might just buy you the time you need to dig out.
“This option transfers your debt to a balance transfer credit card that charges no interest for a certain period of time, usually 12 to 21 months,” said Carter Seuthe, CEO of Credit Summit Consolidation. “They won’t charge any annual fees, but most will charge a one-time balance transfer fee of 3%-5% of the amount transferred. Be sure to calculate whether the interest you save over time will cancel out the cost of the fee.”
Borrow To Pay Off What You Borrowed? Maybe
Seuthe cautions that most balance transfer cards require good credit scores — but if you’re not eligible for one, you might still qualify for a personal loan. Even if you don’t get the best rate, you’ll at least be able to consolidate your debt into one monthly payment at a fixed rate with simple interest instead of a variable rate with compound interest.
Whatever you do, don’t make the mistake that gets so many people into trouble with their credit cards first place.
“The key to making debt consolidation work is that it should be part of a broader debt reduction plan,” said Barrington. “The new loan cannot be seen as an additional source of funds, or you may end up worse off than when you started.”
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