As illustrated in the table above, credit cards are incredibly expensive. They can easily equate to an effective pre-tax interest rate of almost 25% for a person earning up to $90,000 per year. What this means, of course, is that paying down credit card debt will earn a guaranteed 25% pre-tax return per year (under those assumptions). That’s an amazing risk-free rate of return. Of course it would be better to have NO credit card debt.
The biggest problem in managing debts (credit cards and personal/car loans) stems from the fact that a person with these debts is unlikely to have any spare cash available to pay down the debt. A wise course of action can be to consolidate the debts with a loan secured against your home, which will have a much lower interest rate.
A common example of debt consolidation is if you had equity in your house and are paying higher interest rates on personal debts. Consolidation will gain an immediate benefit in terms of reduced interest payments.
Typical moves to reduce or eliminate credit card debt via consolidation can include:
- Consolidating credit card debts by establishing a personal loan to pay out the credit card/s; or
- Consolidating credit card debts into a new credit card facility offering interest free periods on credit card transfers; or
- Consolidating credit card debts by redrawing on a home loan.
Number 1 is an appropriate course of action if you don’t have a current mortgage. But let’s examine options 2 and 3 in further detail.
Making use of an interest free period
In fact, if it is possible, implementing option 2 with either of options 1 or 3 is a good way to minimise the total cost of the credit card interest. It may be necessary to take advantage of the two-stage process if you don’t have the equity in your home or redraw facility necessary to pay out the credit card straight away.
With this approach you would apply to transfer your current credit card debt to another card provider offering an interest-free period. You focus on paying down as much debt as possible before the interest free period expires and the higher rate kicks in (typically after 6-20 months of 0% interest).
After the end of the interest-free period you can then redraw on your home loan to pay out the credit card balance. You will then pay interest on the redrawn amount at the lower home loan rate.
An example of this is highlighted below. Repayments are assumed to be a constant $200 per month (2% of the initial outstanding balance). You will note that the total amount repaid is around $7,000 less and you would save around 3 years with the alternative strategy.
|Credit Card Debt
|Alternative: Interest free card then home loan consolidation
|Interest free card
|Use Home Loan