Role of Interest Rates in Consumer Debt

Paying off debt without interest rates would be simple. Owe $6,000, pay $500 a month, and the debt is gone in a year. Unfortunately, it doesn’t work that way. Credit card companies and lenders charge interest. That’s how they make their money, and there’s no way around it.

When the subject of consolidating credit card debt comes up, it’s all about interest rates. The average credit card interest rate as of June 2021, according to creditcard.com, was 16.13%. The primary goal of consolidation is to get that interest rate down.

The Financial Impact of Credit Card Interest Rates

Let’s assume for a moment that you have a $10,000 credit card balance with an interest rate of 15%. That’s $1,500 a year that you’re paying in interest alone, $125 per month when you break it down. None of that money is applied to your principal when you make payment.

What’s your minimum monthly payment? Let’s say it’s $400 a month. Subtract the $125 in interest from that and only $275 is going toward the balance. Meanwhile, additional interest is added next month for the remaining balance owed. Are you starting to get the picture?

If you do the math, a $10,000 balance with a 15% interest rate will take you 147 months to pay off if you just make minimum payments of $400 a month. That’s 12 years and three months. You’ll pay a total of $4,452.40 in interest during that time.  

Interest Rates for Debt Consolidation Loans

Debt consolidation loans for consumers with average credit scores (640-679) have interest rates that range anywhere from 7% to 30%, depending on the lender. Those with excellent credit can get rates in the 4-5% range. For this exercise, we’re going to assume you’re average and will pay 10%.

One of the nice features of a consolidation loan is that you can choose the time frame to pay off your debt. Your payments will be set accordingly. For instance, a five-year loan for $10,000 at 10% interest will cost you $212.47 a month. That’s a big drop from $400.

It gets better. The total interest you’ll pay over the five years is $2,748.23, saving you $1,700 and seven years of extra payments. That’s a year’s worth of car payments or a nice vacation for you and that special someone. Just try not to use your credit card while you’re there.

Interest Rates in Debt Settlement Offers

A debt settlement agreement is when you offer the credit card company less than the actual balance owed. Keep in mind that when you make this offer, a good portion of the balance is going to be interest owed. Credit card companies will negotiate for that portion.

Before trying to negotiate a settlement, try to find an introductory offer from another credit card company for a balance transfer card. Balance transfer credit cards can typically lower your interest rate, at least for a short period of time. Some cards offer 0% interest for the first year or so, as long as you have good credit.

Going forward, avoid credit cards with high interest rates. Get in the habit of using your debit card whenever possible. There’s no interest rate on that card. You could also, dare we say it, pay cash occasionally. That’s still an option in some places, and can be effective in managing your debt because you’ll physically see your money disappear when you spend it.

About the Author

Kevin Flynn is a former fintech coach and financial services professional. When not on the golf course, he can be found traveling with his wife or spending time with their eight wonderful grandchildren and two cats.

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