Are you beginning to get uneasy about the rising balance on your credit card accounts? Understanding how your outstanding credit card balances affect your credit score can be crucial to avoiding long-term damage to your credit.
But navigating credit card debt and identifying warning signs as your debt mounts can be daunting. Credit cards allow purchases now with payment later. This benefit comes with a cost. There is an old saying that “the odds are always with the house,” and it is true. Over 50 percent of Americans spend more than they earn. (source)
So how do you know when enough is enough, especially if you qualify for a high credit limit and when banks allow for monthly minimum payments. How credit card debt is too much?
How much credit card debt is okay?
According to the Federal Reserve, revolving credit in the U.S. was $960.8 billion in June 2016. If you divide that figure by America’s 122 million households (source), that means the average U.S. household owes $7,875 in credit card debt. With so many people taking on debt at this scale, do the numbers indicate that this amount of credit card debt okay to have on your accounts?
Although having some credit cards is not the end of the word, you should avoid carrying any balance, certainly anything more than a few hundred dollars. After all, the goal is to save and invest money, not pay interest on everyday purchases.
You have too much credit card debt if you:
- Are only paying the minimum payment due every month.
- Sometimes miss payments because you can’t afford them.
- Max out your credit cards.
- Pay credit card bills with other credit cards.
- Feel hopeless about ever paying off your credit card debt.
- Have been charged a penalty for late payments or have been notified by your credit card company of a change in your interest rate due to late payments (i.e., penalty rate).
- Receive a credit-limit reduction without requesting one.
Healthy credit card use
If you pay off your entire balance every month, using your credit cards causes no financial harm. On the contrary, credit card issuers offer ways to earn miles, points, cashback, and other benefits. (Check your card issuer website to see if you are missing out on a cost-saving service.)
However, when you begin to carry a balance, you have to pay interest on your balance each month until that balance is paid in full. In the long term, you end up paying more for your purchases with your credit card than you would have paid if you’d used cash. Put another way, the item you bought because it was on sale will cost more than the regular price due to interest if you don’t pay for it when the bill is due.
When does credit card debt become a problem? This varies from person to person and is mostly dependent upon your ability to pay your card accounts without financial hardship.
Fun fact: credit cards are not charge cards
Most people recognize the primary differences between a student loan or mortgage and a credit card. Many people use the term “charge card” when talking about credit cards. Charge cards are different tools that are relatively uncommon today.
Credit cards have set limits and minimum monthly payments. Charge cards typically do not have a limit, but the user must pay the balance in full by the specified payment date. Failure to pay a charge card puts you in default of the service agreement. You are probably not using a charge card; read the advertiser disclosure to know what type of account you have.
Signs that you have too much credit card debt
The stress of carrying too much credit card debt can prompt people to make poor decisions. You should monitor all of your credit account balances every month. Also, pay close attention to the rest of your finances and patterns of behavior. The signs that you may have too much credit card debt should start to become clearer. Here are some indicators for you to watch for:
- You only pay the minimum payment due every month.
- You sometimes miss payments because you can’t afford them.
- You max out your credit cards.
- You pay credit card bills with other credit cards.
- You feel hopeless about your debt payments and paying off your credit card debt.
- You are charged a penalty for late payments or notified by your credit card company of a change in your interest rate due to late payments (i.e., penalty rate).
- You receive a limit reduction without requesting one.
What does it mean to have unmanageable debt?
There are many warning signs that your debt has become, or is about to become, unmanageable. If you find yourself unable to make minimum payments on your credit card balances or find yourself only paying interest on your card debt and never reducing the principal balance due, your debt has become unmanageable.
How does credit card debt affect your credit score?
Everybody needs a basic understanding of what a credit score is and how it is determined. Your credit score is the three-digit number, ranging from 300 to 850 that lenders use in tandem with your credit report to decide whether or not to approve you for a loan or credit. Lenders also use your credit score to help set terms such as your interest rate and your credit limit.
Three common and well-known credit scores on the market are VantageScore, PLUS score, and FICO score. FICO is the credit score lenders most commonly use.
Your FICO credit score is affected by factors such as:
- The number of accounts you have
- The types of credit accounts you own
- Your credit to debt ratio
- The length of your credit history
- Your payment history
- Credit inquiries
Credit cards affect your credit score in several ways. For instance, late payments to credit card companies will lower your credit score because your payment history accounts for approximately 35% of your FICO score.
Suppose you have several accounts that have been recently opened (as in the case of card accounts you open to take advantage of a 0% interest rate on balance transfers). In that case, your credit score may also be negatively impacted.
All of the above data is combined to determine your score. As you can see, it is much more than making debt payments; your score is an indicator of how responsible you are with your income. In other words, it shows how well do you manage your money.
What is the debt-to-income ratio, and why does it matter?
Your credit-to-debt ratio is also called your open credit card utilization percentage. This percentage represents how much of your available credit card limits you are using at a given time. It can be calculated by taking your total credit card balances and dividing that number by your total limits.
Your credit-to-debt ratio determines 30 percent of your FICO score. When you carry large balances on your card, your open credit card utilization percentage makes your credit score drop. The higher the ratio, the lower your score will be.
Why does your credit-to-debt ratio matter? Lenders believe that if you max out your credit card each month, you are at higher risk of being unable to repay your debt than if you use your card more sparingly. Keeping your utilization percentage under 30 percent of your total credit limit is an excellent way to prevent your credit score from dropping.
What strategies can you use to pay off credit cards?
If your credit card debt is too high, there are several ways to dig yourself back out of your financial hole and pay off your credit card debt. The first thing you can do is work out a budget based on your monthly income, eliminating future credit card spending. Resolving to quit using your credit cards will help you get back on firm financial ground more quickly. In other words, stop spending more than the monthly income your receive. Learning to live within your budget and saving money will ultimately reduce much of the stress out-of-control debt creates.
Here are some specific strategies to help:
Use some of your savings
If you have access to a savings account, you might decide it is worthwhile to pay a lump-sum payment on one or more of your credit cards and jumpstart your journey toward financial freedom. After all, you probably pay much more in credit card interest than the nominal rates that savings accounts currently yield.
Request an interest rate decrease
If your credit score is excellent, credit card companies may agree to offer you a lower interest rate on your existing cards. While this does not always work, it is at least worth a phone call to ask.
Make more than the minimum payment each month
If you make only the minimum payment each month, you will likely spend years paying off your balances. For instance, let’s say that you owe $15,000, and your credit card has an average interest rate of 15 percent. Credit card companies usually calculate minimum payments as interest plus 1 percent (up to 5 percent) of the debt balance. Using this scenario, a $15,000 debt would take over 33 years to repay if you only made minimum payments. That would amount to a whopping $18,230 in interest payments over 33 years. If you think about your credit card balance’s actual cost of interest, you are more likely to pay your credit card debt sooner. If possible, try to double your monthly payment at least.
Transfer balances to low-interest-rate cards
If you have several cards, transfer balances from higher interest rate cards to lower interest rate balance transfer cards. Then, make payments for as much as you can afford on the cards that are left.
Cards with zero or low-interest rates typically offer this APR for a limited time. Make sure to check what the interest rate is after the introductory period. Try to pay off all your transfer balances during the introductory period and avoid accumulating new debt on the card to get the best savings. This strategy allows you to consolidate your credit card debt but should be used to pay it off promptly.
Create a snowball effect
Many people find it helpful to concentrate on paying off one card at a time. To use this repayment strategy, pick the card with the lowest balance and pay it completely off while paying the minimum amount due on all your other cards. Once one card account is paid off, apply the money you paid to the next card on your list. Continue to apply this technique until all your debts are paid in full.
Trigger an avalanche
Another option is to choose the card with the highest interest rate and concentrate on paying it off first. Then, follow through as you would with the snowball effect until all your cards are paid.
When should you consider debt settlement?
Though the strategies mentioned above can work, there are times when you need to be more aggressive. When your debt load becomes unmanageable, it may be time to think about debt settlement solutions.
Debt settlement is the process of negotiating with creditors to reduce your debt balance. Debt settlement companies can reduce debt by as much as 50 percent because professional negotiators work on behalf of consumers to negotiate with their lenders. The strategy typically lowers a consumer’s monthly payment substantially. Debt settlement programs usually last between 24-48 months.
Entering a debt settlement program will have a short-term negative effect on your credit score. Debt settlement helps you avoid the negative impact of a bankruptcy proceeding while reducing the amount you owe on credit cards by a substantial amount.
Debt settlement companies negotiate directly with your creditors to reduce your debt in exchange for a lump-sum payment. These companies do not charge any fees until they settle an account.
Debt settlement and bankruptcy are final solutions to an out-of-control debt situation. When you cannot make your monthly payment or start to fall behind on your monthly bills for essentials such as a mortgage or car loan, debt settlement could be your best option.
If debt collectors are calling, your financial situation is likely already out of control. You may want to consider credit counseling. Many credit counseling organizations offer free counseling regarding your unsecured debt at no cost. For a fee, credit counselors can help you establish a repayment plan to regain control of financial situations.
Credit counselors can guide the best options to resolve your unsecured and secured debt issues. These organizations can assist with budgeting and recommend more aggressive strategies if needed.
A credit counseling organization may help you avoid bankruptcy and debt settlement. It can be tempting to obtain a debt consolidation loan or cash advance when money is tight. Consumers often misuse debt consolidation loans. They acquire the loan with a payment plan they can afford but continue to use their credit cards, effectively increasing their overall debt.
The impact of too much credit card debt
When you carry too much debt, your financial situation suffers. High credit balances impact your debt-to-income ratio and your credit utilization ratio, both of which help determine future interest rates. Your credit health will affect your ability to secure mortgage loans and play a role in determining your down payment for purchases. You can keep more money in your wallet by managing your credit card debt responsibly.
Avoid the debt problem before it starts
Credit card debt problems are avoidable. Before you apply for a card, be aware of the card disclosure. Once you begin using financial services such as securing auto loans, a student loan, a mortgage, or just opening a bank or utility account, you will start to receive credit card offers.
Though credit cards are not all bad, most people fail to use credit cards properly and find themselves with a repayment problem. Credit card services can be advantageous for users if they manage their credit utilization to leverage their financial health’s best outcome.
Know what you applied for
Read card advertiser disclosures, so you know your interest rates, annual fees, and potential penalties. Credit accounts generally have fees if you are late or if you go over your limit. Your credit card balance can increase quickly if you fail to make your monthly payments on time.
If you pay off charges when they are due, you can avoid paying additional interest charges. Most credit cards charge interest on purchases after a specific period. This is usually a date indicated within the billing cycle.
If you open a balance transfer credit card with an introductory interest rate, be clear about your introductory rate conditions in advance. A balance transfer card offers a limited-time initial rate, but the rate can change based on a set term in the credit agreement or as a penalty for failing to make on-time monthly payments.
Debt-to-income ratio: Where do we go from here
Start with knowing your numbers. You need to be aware of your budget, debt-to-income ratio, credit card utilization, and interest rates on your accounts. You also must understand how these compare to your monthly income. In other words, know where your money is coming from and where it is going. Leave wiggle room in your budget for the unexpected and start saving money.
When determining how much credit card debt is too much, you must consider your total financial picture. Card debt is only one element to consider. Are you making monthly payments on student loans, car loans, or a mortgage? These are all part of your total debt picture. You need to be aware of the type of debts you carry and the amount you own on those debts.
Too much credit card debt negatively impacts your debt to income ratio. Student loan debt, your mortgage, and your car loan impact that ratio, even though you are making your payments. This ratio is specifically about your revolving credit accounts. You can improve your credit utilization ratio by paying down your accounts. Check out Supermoney’s guide to improving your credit utilization ratio.
Take control of personal finances
We get it. Creating budgets and calculating the numbers may seem intimidating. You can do it with a little time and information. Start with a guide to personal finance to get the basics. Most people do not know what they have coming in and going out each month.
The first step is creating a budget. First, you must determine your expenses. Expenses include every single thing you pay for, right down to that cup of coffee on the way to work. Review your bank and credit statements to determine all of your bills and include incidental expenses. This is an excellent time to look at how much you spend in interest on your accounts. Seeing what you pay in interest is a great way to get motivated to pay down your debt.
Next, you need to know your real income to determine how much money is coming each month. Include your net (bring home) salary and any additional income from side jobs, alimony, or child support.
The next part is the difficult step. Do the math and see where your balance is after all expenses and bills are paid. In most situations, expenses are more than income. Armed with this information, it is time to start deciding what you can trim from your expenses. The hard part may be giving up your morning latte to pay more on bills.
How much credit card debt is too much? You decide.
Credit card debt is a real problem today. Having a little information about managing or avoiding this form of debt can reduce your stress and improve your financial situation in the long term.
If you do find yourself struggling to pay loans and other debts, contact your finance companies and card issuers. They want you to pay your debt, and they may offer to assist you with temporary solutions that have much milder effects on your credit health.
You can get your financial house in order with little effort and discipline. Credit card debt can be managed by making good choices about your money and living within your budget.