Credit and Debt Blog

(Crystal from California) My husband and I are trying to pull ourselves out of debt; we even overpay on credit cards and cut spending where and when we can, all the little tricks we can. But because of the interest rates, to make any real headway we would have to pay double the payments due. I am so desperate to get away from this cyclical debt that I am willing to accept a loan from family (which we are REALLY uncomfortable with). When all the tips and trick wear out, how can you reduce credit card debt and still have enough left  in the bank for gas and food? And what are the monitary/tax pitfalls of accepting a loan from family?

Dear Crystal:

Loans from family are indeed risky, as your relationship could suffer if you are unable to repay the loan. At the same time, family tends to provide the best interest rate (often zero) for a loan and with no credit check!

To evaluate a family loan, consider the impact if you are unable to repay the loan. Assume that there are situations that could cause a loan default to occur, even if you have every intention of repaying the loan. Job loss and medical emergencies can happen to anyone.

If defaulting on the loan would devastate your family relationship, then you should avoid a family loan entirely. If you believe that your family could absorb a default and would forgive you, then a family loan could be an option.

Paying Off Debt With Debt

Regardless of where a loan comes from, understand that it is very difficult to pay off debt by taking on more debt. It is true that a lower interest rate can speed up repayment of a debt. However, most people that restructure their debt by opening a new debt account end up in worse shape down the road.

Surveys from Brittain Associates and from the Consumer Bankers Association both concluded that of homeowners that cashed out equity in their home to pay off credit card debt, about 30% succeeded. The other roughly 70% had already begun running up credit card balances again within the next 1-2 years.

Many of those consumers probably meant well, but then they faced financial emergencies or further discretionary spending that caused them to go further in debt. The same pressures will apply to any debtor that takes on a loan to repay credit card debt.

Targeted Approach

Since it sounds like you have some additional money each month to pay above and beyond your minimum payments, you might try targeting a single card to gain some momentum. This involves sending nearly all of your extra principal payments toward a single credit card account. This should generally be the account with the highest interest rate.

Cards that have balances split across multiple interest rates should probably wait until later, since any extra payments have traditionally been applied to the lowest interest portion of the balance first. This practice has been outlawed by the Credit Card Accountability, Responsibility and Disclosure (CARD) Act of 2009, which as an effective date of February 2010.

One real distinction that is often missed with this approach is that you cannot send only the bare minimum payment on the other credit cards that you are not targeting first. Any creditor that sees only the bare minimum being paid on an account for at least 6 months may see that as a sign of financial weakness. If they place a “slow pay” classification on the account, you could see the interest rate on that account rise significantly.

The targeted approach is most recommended when you feel you have at least $200 extra to be used toward aggressive debt repayment. If you have less than this, then you should strongly consider completing credit counseling.