When building a budget, we often plan in terms of monthly expenses, but it's also important to think about the big picture — and this is especially true if you've got debt and a poor credit score.
When people are trying to figure out how to pay off their debt, they usually look at how much they can afford to repay each month, says Shanté Nicole Harris of Financial Common Cents. But you should also be looking at how much you'll be paying total over the life of the loan. This is particularly important when deciding to take on new debt, like an auto loan or personal loan.
"Someone might know that 18% is a high interest rate, but they don't really care," says Harris. If the monthly payments work out to $450 per month, for instance, a borrower may consider that affordable simply because they have enough monthly income to cover it.
If you have a subprime credit score, between 580 and 669 on the FICO scoring model, it's likely that you'll be paying higher interest rates than someone with a prime or super-prime score. In 2018, borrowers with a higher-risk profile (i.e. subprime credit score) received credit card interest rates that were 9% higher than super-prime borrowers according to the CFPB's Consumer Credit Card Market Report.
It's also an issue for subprime consumers with installment loans: According to Experian, the average auto loan interest rate for subprime borrowers is 11.92% for new cars and 17.74% for used cars. For deep subprime loans, those rates jump to 14.39% and 20.45%, respectively. These rates are significantly higher than for prime loans (at 4.68% and 6.04%).
It's important to take a deeper look at what the loan costs over its lifetime, Harris says. One of the first things she does with new clients is look at how many outstanding loans they have left to pay off, and then she calculates the interest they are paying on each.
"Do the math and see how much you're going to end up paying for that car over your term," advises Harris. "I have people who say 'I paid $69,000 for this car that only cost $29,000 when I bought it!'"
"The next question is always 'Okay, what can I do now?'" Harris says.
The first thing you should do if you're stuck with sky-high interest rates is find out exactly how much you're spending on interest charges each month. This goes for credit cards as well as student loans, mortgages and any installment loans you're paying off.
"Pull together all your statements for 12 months and jot down the interest you pay," says Harris. Then, consider what else you could be doing with the money instead. This is an important lesson that can help prevent you from taking out expensive loans in the future.
Once you have a clear picture of how much debt you have and how much interest you're paying, you need to make a plan to pay off the debt — and build credit while you do it.
Step 1: Make a debt payoff plan
Two of the most popular debt payoff methods are the snowball and avalanche methods. With the snowball method, you prioritize paying off the debt with the smallest balance first. With the avalanche method, you focus on paying off the balance with the highest APR. The avalanche can save you a little more money in interest charges, but often people find the snowball method most motivating because you gain momentum when you have a quick win paying off your first balance.
If you do have good or excellent credit, you'll have a few more options for managing your debt. Consider opening a balance transfer card, such as the Citi® Double Cash Card. For a fee (usually 2% to 5% of your balance), you can transfer your debt to a new card and pay it off with 0% interest for a temporary period, usually 12 to 18 months. If you go this route, make sure you have a clear debt repayment plan.
You might also want to look into a debt consolidation loan. This option lets you streamline multiple debt payments into one monthly bill. Personal loans typically come with lower interest rates than credit cards. If you qualify, you can take out a personal loan large enough to pay off all of your debt, and then you pay back your lender in monthly installments over the course of the loan. Be careful not to confuse debt consolidation loans with debt settlement, which is when you pay a company to negotiate your debt on your behalf.
If your credit score is so low you don't qualify for a balance transfer or debt consolidation loan, working with a trusted credit counselor can help you put together a manageable debt repayment plan. Do your research and make sure you understand the difference between debt consolidation, credit counseling and debt settlement. Check out the National Federation for Credit Counseling (NFCC) and the Financial Counseling Association of America (FCAA) for directories of their accredited member locations.
Step 2: Don't wait to repair your credit
Simultaneously, you should be working toward repairing your credit score so that you can have better lending options in the future. The fastest way to do this, Harris says, is to use a credit card responsibly while you work to pay off your debt.
"Lenders don't want to see all revolving lines or all installment lines," she says — it's important to have a mix of credit. But of the two kinds of debt, "credit cards are more important" for your credit score. Unlike loans, credit cards impact your credit utilization rate and demonstrate to lenders that you have the discipline to pay back a fluctuating amount each month.
Secured cards like the Capital One® Secured Mastercard® are great for building credit. Becoming an authorized user on someone else's credit card can also help you improve your score by "piggy-backing" off of theirs (just make sure they have good credit before you do). Credit cards that don't charge authorized user fees include: Chase Sapphire Preferred® Card, Capital One® Venture® Rewards Credit Card, Bank of America® Cash Rewards credit card and Citi® Double Cash Card.
Read about these three alternatives ways that subprime borrowers can build credit.
If you've found yourself stuck in an expensive lending cycle, don't despair. Often, a credit wake-up call can catalyze big changes that ultimately improve your financial picture and save you money in the long run.
"It's really psychological, and that's the part I love," says Harris, who repaired her own subprime credit score after paying off $50,000 of debt. She encourages those who are currently in debt or grappling with high-interest loans to "dig deeper into why this is actually happening."
"No one can fix your credit for you," Harris says. The road to credit repair may be difficult, but it is ultimately satisfying in the end.
Information about the Capital One® Secured Mastercard®, Capital One® Venture® Rewards Credit Card, and Bank of America® Cash Rewards credit card has been collected independently by CNBC and has not been reviewed or provided by the issuer prior to publication.