Given that Punxsutawney Phil saw his shadow and we are therefore in for six more weeks of winter, a trip to the islands sure sounds good right about now. Interestingly enough, the same holds true in light of the rate at which consumers are racking up credit card debt.
After beginning 2011 by paying off nearly $33 billion in outstanding credit card bills, U.S. consumers have used the rest of the year to gain it back at a record clip. While the final numbers are not yet in, they are projected to have ended the year owing around $64 billion more than they owed when it began, according to the most recent credit card debt study by the credit card comparison website Card Hub. One of the most efficient ways to pay off credit card debt is called the Island Approach, which involves segmenting your different needs on separate credit cards, almost as if they are stranded on islands.
There are five main benefits to the Island Approach – three related to paying off what you owe and two dealing with how to maximize the free money your credit card gives you once you realize the goal of paying off what you owe.
Paying Down Debt
1. Instills spending discipline: According to the Island Approach, you should have separate credit cards for revolving debt and everyday spending. This allows you to clearly evaluate your spending habits given that an inability to pay your everyday-spending credit card’s balance in full during a given month will clearly signal that you are spending beyond your means and need to cut back. Having built-in “wake up calls” like this helps to ensure that you stop adding new debt, which will, of course, make it much easier to pay down that which already exists.
2. Lowers your average monthly balance: Separating debt from everyday spending also lowers your average monthly balance, which in turn lowers your monthly interest tab. You see, if you have both on the same card, interest will be applied to the total of your debt and daily expenses. On the other hand, if you separate them, your everyday expenses will benefit from a grace period, which means the balance associated with your everyday expenses will not incur any interest. The end result: you save money on a monthly basis.
3. Provides for favorable payment allocation: This approach also helps to ensure that you have no more than one balance on a single credit card and therefore that you benefit from favorable payment allocation. When you have two or more balances on the same card, only the amount of your monthly payment above the minimum required gets applied to the balance with the highest interest rate. In other words, it will take longer to pay down the most expensive debt. On the other hand, if you were to have two balances on two different cards, you could strategically allocate payments in order to make paying off what you owe as painless to your wallet as possible.
Maximizing Free Money
1. Allows you to minimize the cost of interest: The Island Approach is also integral to finding the best credit cards for your needs. Instead of trying to find one that will address all of the different types of transactions you’ll have to make – a futile effort since credit card offers usually only excel in one area – you can focus on getting the best possible feature for a given type of transaction. You see, if you want the best introductory balance transfer rate, you’re not going to find it on the card offering the best rewards.
2. Allows you to maximize rewards: The same obviously holds true for maximizing your rewards potential after you have paid down your debt as well. Instead of finding a single credit card with decent rewards across all purchases, you can get the best possible rewards for each of your biggest expenses. Imagine, for example, that you travel a lot for business and always stay at Hilton hotels, enjoy personal travel as well, and spend a lot on gas and groceries each month. Using the Hilton Credit Card for your business trip reservations, a card like the Blue Cash Everyday from American Express for gas and groceries (3% at supermarkets and 2% on gas), and the Capital One Cash Credit Card for everything else (1.5% across all purchases) would allow you to save the most money possible.
So make like a jet-setter and head to the islands now, and if anyone asks, just tell them that you’re doing it for your wallet. After all, your wallet will thank you.
This article was written by Odysseas Papadimitriou, CEO of Card Hub, a credit card comparison website.