High Interest Rate Card Debt
Why It's Best to Pay High Interest Rate Credit Cards First
If you have multiple debts, chances are they have different interest rates, some higher than others. In a debt payoff plan, it's best to pay the credit cards with the highest interest rates first - from a financial standpoint at least.
The Cost of a High-Interest Rate
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 card, the more money it costs you because you pay more in finance charges when you pay the debt off slowly. Paying off high-interest rate debt first saves money and usually lets you pay off the debt faster.
How Interest Rates Affect Your Debt Payoff
Here's an example to demonstrate:
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. You'll pay a lump sum toward one of the debts and pay just the minimum on the other. (This is the most effective way to pay off multiple credit cards.)
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.
Could Paying the Smaller Balance First Work?
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 of paying off smaller debts first 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.
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.