Why It's Best to Pay Your Highest Interest Rate Credit Cards First
Americans hold more close to $1.1 trillion credit card debt according to the Federal Reserve. If you have balances on multiple credit cards—Experian reports Americans hold an average of four credit cards each—chances are they each have different interest rates, some higher than others. When you're weighing the best order to pay off your credit cards, you'll save more money by focusing on the balance with the highest-interest rate first.
The Cost of a High-Interest Rate Credit Card
It costs more to carry a balance on a high-interest rate credit card. That's because your monthly finance charge is based on your interest rate and your balance—the higher your interest rate, the higher your finance charge will be. Not only that, the longer you take to pay off the balance, the more money it costs you.
Credit card interest rates are based on a number of factors: the economy, the type of credit card, your creditworthiness at the time you applied, and whether you've defaulted your payments.
Paying off high-interest rate debt first saves money and usually lets you pay off your total debt faster.
How Credit Card Interest Rates Affect Your Debt Payoff
Let's say you have two credit cards.
- Credit Card A has a $3,000 balance and a 22% interest rate.
- Credit Card B has a $1,500 balance and a 12% interest rate.
Let's also assume you can put $150 toward paying off these debts. The most effective way to pay off multiple credit cards is by paying a lump sum toward one of the debts and only the minimum on the other.
If you pay off Credit Card A first, you will pay a total of $1,283 in interest, and it would take 39 months to become debt free. On the other hand, if you paid off Credit Card B first, you'd pay a total of $1,764 in interest, and it would take you 42 months to become debt free.
Paying off the high-interest rate debt saves $481 in interest, and you'll pay off the debt 3 months sooner.
Does It Ever Make Sense to Pay Off the Smallest Balance First?
Paying high-interest rate debt first makes sense from a financial standpoint, but that method isn't best for everyone. Dave Ramsey, millionaire-gone-bankrupt-turned-millionaire, suggests the snowball method to pay off the card regardless of interest rate. He argues that when small debts are paid off sooner, you remain motivated to pay off the next debt and the next until you're debt free.
It's true that the smallest-balance-first method lets you pay off some debts sooner in the beginning. In our example above, under the highest-interest-rate-first method, you'd have the first card paid off in 31 months. Under the smallest balance first method, you'd have the first card paid off in 14 months. Having an account completely paid off is a great feeling. But remember, it takes you longer to pay off the debt completely under the smallest-debt-first method, which results in more interest paid overall.
If you have credit cards with high interest rates, consider asking your card issuer for a lower interest rate. There's a chance your request will be granted if you've kept your account in good standing.
How to Decide Which Credit Card to Pay Off First
When you're ready to pay off your debts, you have to decide if you need the motivation from paying off smaller debts at the expense of spending more money on interest. Don't spend too much time thinking it over; the important thing is that you get started even if it means paying off some debts quickly.