For those struggling with credit card debt, coming up with a repayment plan can be a challenge. Should you focus on the highest-interest card or the one with the lowest balance? What if you have student loans or car loans mixed in? Dealing with so many different monthly payments at once can be overwhelming.
The Motivational Perspective
Which credit card you deal with first depends on two factors. First, there’s the psychological aspect. Many people tend to pay off the lowest-balance card first because of something known as “debt account aversion.” That is, we aim to limit the number of open accounts we have.
Paying off the smallest card first means one less account we have to deal with. Getting rid of one balance is a small victory, which gives us motivation to move forward with our plan. Experts have come up with a cute name for this strategy: Debt snowballing. The idea is that you build momentum by paying off smaller accounts first, then putting those payments towards larger accounts.
This path certainly makes sense from a motivational standpoint, but is it best for you wallet? You also have to consider the financial aspect of debt repayment.
The Financial Perspective
From a purely financial perspective, paying off the highest-interest card first makes the most sense. Using this method you’ll pay less in total interest to the credit card company and reduce the time it takes to repay the debt.
Let’s say you have two credit cards. One card has a balance of $8,000 at 19% and the other is $5,000 at 15%. Both have minimum payments of $40. Psychologically, you’d be tempted to pay off the $5,000 balance first to eliminate one of the accounts. But I’ll show you why this is bad for your wallet.
Making the minimum payment, it will take you over 10 years to pay off both balances. But since you’re on top of things, you have an extra $300 to put towards the cards each month beyond the minimum. Where should you put this extra money?
By paying $340 to the $5,000 card and the minimum to the $8,000 card it would take you 49 months and cost $5,575 in total interest.
On the other hand, by paying off the larger card first it’ll take you 47 months and cost $4,754 in interest. Focusing on the higher interest rate first saves you $821 and will take you 2 months less to pay off both balances.
You’re probably thinking that $821 is a lot of money, and you’d be right. But let’s say you cut back on eating out, giving you an extra $100 a month to put towards the cards. It will now only take you 35 months to pay off both balances, a full year less. Not only that, it will save you another $1,343!
Applying every bit of extra money you have each month to debt repayment is known as “snowflaking.” Snowflakes can come from anywhere – income from a side job or savings from decreased expenses.
Which Strategy is Right for You?
Your repayment plan should depend on your personality. If you’re very disciplined with money, focusing on the highest-interest card first is probably your best strategy. On the other hand, if you think you’ll need small victories as motivation to stay in the game, paying off low balances first (the snowball method) might be your best bet.
No matter which strategy you choose, your goal is the same: to pay off the debt. Having the numbers in front of you will only increase your focus. Use a debt repayment calculator like this one to help you build and track your strategy.
Which repayment strategy makes the most sense to you?
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