Credit card debt can arise for a variety of reasons.
Some people get hooked on swiping their cards for discretionary items like clothes and household items, or leisure activities like eating out or watching movies. Some people don’t have the cash to cover emergencies like car repairs or medical issues. And many Americans rely on credit cards to get by, especially as prices for essentials like gas and groceries remain soaring.
Regardless of how you got there, you need to be careful if you’re facing a large debt balance or are at risk of spiraling out of control. Credit cards typically have high interest rates, so the monthly minimum payment usually doesn’t have much, if any, impact on your principal balance. According to LendingTree, a $5,000 balance at an average interest rate of 23.79% will earn you nearly $100 in interest each month. This means you’ll need to pay more than that amount to actually reduce your balance. According to LendingTree’s payoff calculator, you’ll need to pay at least $472 a month to pay off your debt in a year, assuming you don’t add anything to your starting balance.
Now, imagine that you are working to lose your balance and an emergency occurs. If you don’t have cash funds set aside to cover it, your monthly debt service costs can increase beyond what you can realistically afford.
Cassandra Rupp, senior wealth advisor and certified financial planner at Vanguard, says paying off debt while saving for emergencies can be a difficult balance. But to avoid a debt spiral, it’s important to do a little bit of both at the beginning of your journey.
“Unfortunately, debt tends to snowball. You have to prioritize: Here’s this[emergency expense]how are we going to recover this, and how are we going to save up in our emergency bucket so this doesn’t happen again,” she says.
Start with an emergency fund
It may be tempting to put all your available money toward credit card debt, but if you don’t have an emergency fund, Rapp says that’s where you should start. Whether you’ve recently drained your savings for emergencies or simply haven’t prioritized building your funds, it’s important to give yourself a financial buffer so you don’t sink further into credit card debt or abandon other financial goals to cover large unexpected expenses.
“The first thing I always say is make sure you have an emergency savings bucket,” she says.
She recommends aiming to save $2,000 or half a month’s worth of expenses, whichever is greater, to get started. In the long term, she says you should have three to six months’ worth of living expenses saved in case you lose your job or another source of income.
At the same time, Rapp says you should take advantage of “free money,” such as maximizing the benefits of your employer’s 401(k) match. If you can do it while saving cash for emergencies, even better.
Avoid “excessive” savings if you have high-interest debt
Rapp recommends making at least minimum debt payments while working on other priorities, such as building an emergency fund or making common-sense contributions to a workplace retirement account. But don’t fall into the trap of saving too much cash, she says.
While increasing your savings is generally a good thing, you’re unlikely to earn more than a few percent in interest on unspent cash. On the other hand, your credit card balance may be growing at an annual rate of 20% or more. If you’re building up extra cash in savings, “consider putting that savings towards paying down debt, which will improve your overall financial health,” Rapp says.
This is a fairly common problem. A recent Vanguard study found that 57% of investors with credit card debt have the funds to pay it off. Investment firms have found that many are contributing more to their 401(k) than their companies are worth or making additional payments on low-interest debt, such as mortgages. But such strategies can create a “false sense of security,” Rupp said.
“Seeing this cash bucket grow and knowing it’s available right away feels better than going into debt,” she says. “You may feel like you could use more of your assets or make summer plans, but in reality it should have gone toward debt.”
Plan and automate
Once you have a solid emergency fund in place, you can focus more on reducing your debt balance. Rapp says your personal situation — how much debt you have and what your interest rates are — can help you determine how much you should put toward debt and how much you should keep saving.
No matter how you divide it up, Rupp recommends setting up automatic transfers so you can put money toward savings or credit card bills before you spend it.
“When you’re at that point and you have a little extra, even if it’s a very small amount, having some sort of automated plan for making high-yield savings is like (it’s) out of sight and out of mind. It’s already planned for you. So it makes things a lot easier for investors,” she says.
Additionally, if you receive a cash windfall, such as a bonus or tax refund, have a system in place to use some of that money to save or pay off debt. That said, Rapp doesn’t recommend relying on that money to cover periods of high spending.
“I always don’t want to spend money up front,” she says. “From an emotional standpoint, having something coming up and it already being spent and having no flexibility puts you in a bad situation.”
To maximize flexibility, Rapp generally recommends planning for the unexpected, and it helps to know where you stand financially and what your priorities are.
“Being calm and planning takes a lot of weight off your shoulders,” she says.
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