This questions harks back to my original intent for writing these articles and that is to simplify financial advice and the answer is equally simple.
Once you have reached your credit limit, you have to stop spending and therefore can limit your damage.
So how can we use Credit card limits to our advantage?
Today I’m going to give you a scenario to think about that I see on a regular basis and you can decide whether the picture I’ve painted approximates your life. If so, help is at hand
A new client comes to me and as part of their position, state that they have a $20,000 personal loan for a car and a credit card (they got for emergencies) which is now at it’s limit of $10,000. Conventional wisdom states that this client should pay off their credit card first as it charges a much higher interest rate than the personal loan.
Sounds logical right? Wrong! This scenario assumes that we are all common sense activated and only operate by logic. If we were completely logical the client would have saved up for the 10k in purchases they are now paying interest for.
“But wait” I hear you say. “My credit card allows me to make purchases on the net”. For those that still think that we’re completely logical and can save for all our purchases, then I have two words VISA DEBIT.
“And what about the higher interest rate?”. My opinion based on what I have seen over the last 13 years is that interest rates are always secondary to strategy. Most people will screw up their strategy long before interest rates come into play. That is, if they have a strategy.
Let me explain how this could be. Let’s assume that you’ve just gotten your tax refund and have received a cheque of $2,000 which you’d like to use to reduce your debt. Because your credit card has a high interest rate, you deposit the $2k there to reduce your balance and diligently promise yourself that you’ll never let it get that high again.
You go on living your life as per normal and next thing you know, the electricity bill arrives along with it’s good friends phone bill and car service reminder and it’s still 4 days to pay day. So what happens next is as predictable as the setting sun, you jump online and with a wave of your magical credit card wand the bills are paid and the promise you made to yourself is forgotten just as quickly.
So what would have happened if you put the money into your personal loan instead?
Well, firstly you might have had to stay home a few more nights and bought a cheaper bottle of wine but you would have still paid the bills and even more importantly, you’re debt would not have increased.
So here is my suggested strategy if you do need some help to develop new habits.
I use the percentages espoused by George S. Clason in “The richest man in Babylon” and recommend that you deliver 20% of your take home pay to debt payment and the way that this would apply in this example is easy. Make only your minimum monthly repayment on your credit card and deposit the entire remainder to your personal loan, knowing deep in your psyche that you cannot redraw this money.
By the time you have paid out your personal loan, which wil be much quicker, you will have developed better money management habits and are ready for the credit card strategy and this is just as easy. You now deposit all of the previous payments to the credit card that you were previously making to the personal loan. However, to ensure that “emergencies” don’t tempt you again, reduce your limit by $1,000 or $500 each time you hit the new marker. This will ensure that you regain control of that cashflow which seems to trickle through your fingers and may even give you some more choices in life.
More holidays, more time with family, or even a new home. All paid for with the money you used to give to your credit card provider.