DEBT MANAGEMENT

Using credit cards well - transactors and revolvers

What to do if you are a revolver

Credit cards and small businesses

Comparing credit cards

Chapter 3 - Consumer debt and how to manage it

Consumer debt is debt taken out to buy consumer products and services. Consumer debt is usually very expensive – some credit card debts charge up to 20% per annum – and is not tax deductible because it does not relate to assessable income. Again, if you pay tax at 30%, the effective pre-tax rate on a 20% credit card becomes almost 29%. Looked at another way, if you pay interest on a credit card then you effectively increase the price of everything you buy by 30%. Something you buy for $1,000 actually costs you $1,300.

And if you do not pay the card off quickly, the price actually doubles every 2 and a bit years.

What’s worse, credit cards are typically used to buy consumable goods and services, which fall in value over time – and especially as soon as you buy them. This means that if you pay interest on credit cards, you have increased the price of something that immediately falls in value. We call this a ‘double-whammy.’

Some consumable goods and services are unavoidable. Food, shelter, clothing, and health are all things people need. They are often referred to as non-discretionary consumable items, as the buyer does not really have the discretion to decide whether to buy them. But other consumable items are what is known as ‘discretionary.’ If you do not buy them, you will still be OK. Using a credit card to buy discretionary items is a really bad idea.

Not all credit card purchases attract interest. Most cards allow an interest-free period. If the user of the card pays the credit card bill in full before interest charges are applied, then they do not pay interest. However, only 30% of credit cards are repaid within the interest-free periods, meaning 70% of credit card users pay interest.

The following sections discuss various strategies for best managing credit card debt. We recommend that you speak to us before you implement any of them, as they often require you to do some other things correctly as well.

Using credit cards well – transactors and revolvers

 

People who never pay interest on their credit card use the card merely for convenience. Credit cards allow payment to be made in various settings, including over the phone and online. Essentially, the credit card provider works as an intermediary, removing the need for the purchaser and the seller to have a direct credit contract between them. Instead, the purchaser and the seller each have a contract with the credit card company. It makes life much easier.

 

People who use credit cards for convenience are often referred to as ‘transactors.’ Investopedia defines a transactor as:

 

A consumer who pays his or her credit card balance in full and on time every month. Transactors do not carry a balance from month to month; they always pay their credit card bills in full by the due date. Transactors do not pay interest or late fees.

 

There is no problem in being a transactor. You are not really borrowing money for these purchases, because you never pay interest. You are using the card merely to make life easier – which often improves our financial bottom line, as well. You might pay a relatively small annual fee for the convenience of the card, but this fee can often be offset by the rewards program that the credit card provider make available.

 

Most transactors arrange for the balance of their credit card to be automatically repaid using direct debit each month. This means that they never incur interest on the card.

 

Consumers who do not pay the balance of their credit card off each month, and who thereby incur interest on their card, are sometimes referred to as revolvers. This word is used because these people just go around and around in debt. Their credit card debt is real debt, and needs to be paid off.

WHAT TO DO IF YOU ARE A REVOLVER

 

So, be honest: are you a transactor or a revolver? If you are a revolver, then you really should do something about your credit card debt. Remember, we saw above that the effective pre-tax rate of interest on credit cards can be as high as 29% (and this is for people in the 30% tax bracket. The effective rate is higher if you are in a higher tax bracket). But there is some good news: if you can pay off some or all of your interest-bearing credit card debt, you earn a guaranteed 29% pre-tax return per year. This is simply the best investment return you can get, especially seeing that there is no risk involved in paying off debt.

 

So, what can you do to reduce or eliminate credit card debt? Well, firstly, if you have the cash, use it to pay off the debt. But, given you have the debt, we assume you do not have the cash. In that case, the best way to reduce credit card debt is usually some form of consolidation. Consolidation means combining one or more high interest loans into a loan with lower interest.  Consolidation strategies can include:

  1. Consolidating credit card debts by redrawing on a home loan;

  2. Consolidating credit card debts by establishing a personal loan to pay out the credit card/s; or

  3. Consolidating credit card debts into a new credit card facility offering interest free periods on credit card transfers – and then working feverishly to eliminate the debt during the interest-free period (after which the credit card issuer starts to charge an even higher interest rate).

 

Regarding number 3, we cannot stress enough that it is a temporary measure only. Don’t consolidate the debt and then leave it unattended. You should only use this strategy if you are able to repay the entire debt during the new card’s interest-free period.

 

Have a look at this graph, which shows the effect of consolidating a credit card onto a home loan. The graph assumes that, having used the home loan to pay out the credit card, you then use the money that you would have had to repay on the credit card to repay the home loan. Because you are no longer spending money paying interest on the credit card, you actually reduce the length of the home loan by more than 15%.

 

What the graph shows is the expensive credit card debt restricts your ability to repay your home loan as well. Sometimes, consolidation cannot occur. But there are still some things that you can do. Consider the following:

  1. Where there is more than one credit card: target the card with the highest interest rate applicable to be repaid first;

  2. Where there is more than one credit card: target the card with the lowest balance first. This might not be as good as the option above, but a lot of people find that they are encouraged by the ability to completely repay one balance and this is the best way to get started;

  3. Negotiate with the credit card provider; or

  4. Sell something and using the proceeds to pay down debt.

 

This last step might seem drastic, but if you sell something for $1,000 and then use it to pay off debt, you not only have less debt: you save yourself an extra $300 or more in pre-tax interest. This means that selling things increases the value of them. Selling something for $1,000 makes you $1,300 better off – and this is just in year one.

Credit cards and small businesses

For transactors, credit cards provide a simple way for a small business to manage its record-keeping. Consider a psychologist operating her own small business. She will probably have a private credit card which she uses for personal expenditures such as groceries or petrol. If she uses the same credit card to pay her business expenses, then at the end of each month she needs to manually review her credit card statement to identify those expenditures which can be treated as deductions when calculating her business profits.

 

A better way is to acquire a second credit card and to use that credit card exclusively for the bills which apply to the business. By doing so, the monthly credit card statement becomes the record of the various expenses it was used to facilitate. These days, the statement is usually digital, and the information can be provided directly to her financial adviser or her financial management software.

 

If the business has a loan facility such as an overdraft, she can even organise for that facility to be used to pay the credit card balance by direct debit at the end of each month. Direct debit should always be used, to ensure that interest is not incurred on the credit card. It also means you will never forget to pay the balance. This ensures you will be a transactor. Provided that the expenditures were for legitimate business expenses, this will not compromise the deductibility of the interest on the overdraft.

 

Many people who use credit cards in this way make the ‘work’ credit card a completely different colour. Something as simple as ‘blue card for me, yellow card for the business’ often works well.

Comparing credit cards

 

Not all credit cards are alike. Here is a short video produced by the Australian Securities and Investments Commission, and presented by Deputy Commissioner Peter Kell, discussing how to go about selecting the best credit card for your purposes:

2. Other personal debt and how to manage it 
4. Investment debt and how to manage it

 ©2016 WHOLE WEALTH

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