Debt Smarts: Which credit card should I pay off first?
Since I wrote the column on paying off credit cards using the snowball effect, I've received numerous questions asking whether it's better to pay off the cards with the lowest balance first or pay off the cards with the highest interest rate first. Personally, I think it's best to pay off the highest rate cards first, no matter what the balance is on the cards. I know others believe it's best to pay off the cards with the lowest balances and then work up to the ones with the highest balances no matter what the interest rate, getting rid of payments to build up that snowball as quickly as possible.
Actually the best way to get started using the snowball effect is to transfer all your high interest rate credit card balances to cards with the lower interest rates, if that is an option for you. For example, suppose you have $5000 on a credit card that charges19.99% interest and you have $2,000 on a credit card that charges 9.99% interest. If you can reverse that and transfer $3,000 to the 9.99% interest card, do that before you start working on your payoff. Many cards even allow you 0% interest on the first six months after transfer, which helps even more.
But even if you can't transfer those balances, you're still better off paying off that higher interest credit card first. If you have $5,000 on a card charging 19.99% interest you are probably paying about $84 in interest per month and the minimum payment is probably about $100. The $2,000 card at 9.99% interest probably has an interest charge of about $17 per month and a minimum payment of about $20 per month. Since most cards calculate interest based on daily compounding, interest payments could be higher than those I've calculated. But we'll use to keep things simple.
Suppose you've found $500 per month in your budget that you can use to pay off your credit cards. You could pay off the $2,000 card at 9.99% in about fiveand a half months and then work on the $5,000 card or you could make minimum payments on the $2,000 card and start working on the $5,000 balance at 19.99%. Which should you do?
If you start on the $2,000 card, the first month you would pay the $100 minimum payment on the $5,000 and then pay $400 on the $2,000 card. After that payment your balance on the $2,000 card would be about $1616.70. Your balance on the $5,000 card would be $4,983.73. The interest the next month would then be $13.47 on the $1616.70 balance but would be $83.70 on the $4,983.73 card. Since you only paid $17 on the balance of the card to which you are paying 19.99%, your interest payments stay about the same.
Over a five and a half month period you would pay off the $2,000 card and pay about $51 in interest, but during that time you'd be paying very little on that card that started with a $5,000 balance and the total interest you'd pay during the five month period would be about $415.
Now let's reverse that decision and pay $480 toward the $5,000 card with the 19.99% interest rate and just $20 toward the $2,000 card. In five months, the balance on the $5,000 card would go down to about $3,400 and your total interest would be about $350. The amount going toward interest each month after those five months would then be about $56 rather than $84. You would not have paid much down on the $2,000 card, but the total interest there would be $83, about $30 higher in total interest on that card in the same period. You would pay half the interest over the payoff of both cards and be in a much better position to get rid of the higher interest rate card faster.
The snowball effect works best if your primary goal is to get the cards paid off the fastest with the least amount of interest. The round robin plan is better to use if you want to improve your credit score more quickly.
Lita Epstein is the author of more than 20 books including the Complete Idiot's Guide to Improving Your Credit Score.