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Employ this strategy to get your debt down and extra cash in your pocket.
When you have more than one credit card to pay off, there are many ways to go about tackling your debt. You could pay off cards with highest interest rates first, or you could pay off cards with the smallest balances first. Or, you could make bigger payments toward cards with larger balances, and smaller payments toward cards with smaller balances.
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It matters which order you pay off credit cards if you want to get out of debt quickly. Unfortunately, most people are going about it the wrong way.
Going above the minimum
When you get your credit card bill, it will state the minimum monthly payment you are required to make, typically 2 to 5 percent of your account balance. This minimum payment amount will avoid you having to pay late fees and will keep your credit score stable, but that’s about all it will help with. Depending on the interest rate, it could take you over 30 years to pay off a credit card making only minimum payments. If you want to pay off your credit cards in a reasonable amount of time, you will need to make more than the minimum payment every month. (See also on WiseBread.com: All the Ways Minimum Payments Are Evil)
How should you distribute additional payment funds that are above the minimum payment amount? Which card (or cards) you pay down first can make a big difference in terms of how long it takes to get out of debt and how much it costs to pay off the debt. It turns out that most people are using a repayment strategy that takes longer and costs more than necessary.
The trouble with balance-matching
According to a recent study conducted in England, a majority of people who are making payments on multiple credit cards are using a repayment strategy that can be described as “balance-matching.” Credit card payments are allocated in proportion to the balance on each account — in other words, bigger payments go toward cards with bigger balances, and smaller payments go toward cards with smaller balances.
The problem with the balance-matching repayment strategy is that it completely ignores the interest rate on credit accounts, which is a major driver of how long it takes to pay off debt. If credit card payments are allocated only based on the account balances, higher interest accounts can rack up interest and you can end up stuck in credit card debt longer and paying more before you finally get the debt paid off.
Why do people use a repayment strategy that ends up costing more? The likely reason is that people are more familiar with their credit card balances than the interest rates on various cards. The balance is easy to find on the credit card bill in contrast with the interest rate, which can be buried in the small print. So when people decide how much to pay toward their credit cards, the balance tends to be the biggest factor — or the only factor — in deciding how to allocate payments.
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The right way to pay off credit cards
If you want to pay off credit card debt in the shortest time for the lowest cost, the optimal payment strategy is to direct additional payments to the highest-interest rate card first, and continue making minimum payments on your other cards. When your highest-interest card is paid off, you’ll direct extra payments to the next highest-interest card, and so on, until your debt is eliminated. This strategy is sometimes described as the debt avalanche method. The debt avalanche method ignores the balance of credit cards and uses only the interest rate to determine how to allocate payments. The result of following the debt avalanche strategy is that balances at the highest interest rate are paid off as quickly as possible, minimizing the cost of interest.
Another effective payment strategy for a lot of people is the debt snowball method. In this approach, you direct additional funds to the card with the smallest balance while making minimum payments on the others. Once you pay off your card with the smallest balance, you move on to direct extra payments toward the card with the next smallest balance, and so on. The debt snowball method provides psychological reinforcement as credit accounts are paid off. Even though this strategy ignores interest rates, seeing quick results of paying off credit accounts with lower balances can motivate people to stay focused on paying off debt.
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Consider a balance transfer
If you are really committed to a debt payoff goal, a balance transfer can save you thousands in interest and help you meet your goal earlier. By transferring your balance to a credit card with a 0% balance transfer offer, you can buy time, interest-free, while paying off your debt. Now, this is assuming you would qualify for a new card with a high enough credit limit to make it worthwhile. But if your credit is solid (you just have a lot of debt), this could be the best option to getting your debt paid once and for all.
This article is from Dr Penny Pincher of Wise Bread, an award-winning personal finance and credit card comparison website.
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This article is from Wise Bread, not the Kiplinger editorial staff.