Doing the Math: Credit Card Payment Priority
An unfortunate Truth for many Americans is that credit card debt is a real and personal thing. While we don't recommend find anything on credit that you can't pay for immediately, it is still important to understand how the best pay off credit card debts in the event that you or someone you know end up in that situation. So today we are going to talk about the math behind credit card debt and what you should do if you find yourself in a situation where you need to pay off multiple debts.
The Qualitative
Before we jump into the numbers, it’s important that you understand the qualitative factors of this debt. Regardless of any excess income you have, you should still follow a few rules when tackling your debt:
Make the minimum payments on everything if possible. When you do not make the minimum payments on your credit card balance it can hurt your credit score, which can lead to much bigger problems in the future beyond holding some owing money at a high interest rate.
Maintain your health. When people find themselves in credit card debt and really want to get out of it, they take every necessary measure to reduce their spending so they can pay off the debt as quickly as possible. There is nothing wrong with this if it is controlled. Important thing to remember is that the debt will not matter if you are dead. So, do not skip too many meals just to pay off that balance.
Keep an emergency fund. The reason why some people can get into credit card debt is because they did not have an emergency fund in the first place, and some large expenditure came up. It would be terrible if you spend every spare dollar on paying down your credit card debt only to have another emergency which require you to go in the more credit card debt. Keep in mind size of this emergency fund is not the typical personal finance 3 or 6 months savings, but more of a lump-sum to get through general expenditures between paychecks if necessary.
Paying It Down
Now here is a section that you came here for which will aim to answer the question "what debt do I pay off first?" After making the required minimum payment so your credit score doesn't get hurt, the mathematically correct answer is the pay off the debt with the highest interest rate. Interest is the cost of borrowing money, and the only difference between the dollar being borrowed from one company versus another company is the cost of borrowing it.
Look at this example below and see what happens. The numbers we use will assume that all required payments have been made and that interest is only based off the outstanding balances listed below.
Let's say you have three cards:
Card A has a balance of $500 at 24% interest
Card B has $1,000 at 15% interest
Card C has $200 at a promotional 0% interest rate for the next 8 months
Here's what happens if no payments are made:
Although Card B has the largest balance, it does not generate interest the fastest out of all the cards (Card A is generated interest at the highest rate). And Card C is not costing you any money due to its promotional rate. The total interest that would occur if nothing happened is $22.50.
Let's say you have $600 to put towards this debt. We can figure out which option is the best I seen what would happen if we use three different strategies:
Paying the largest balance first
Paying the smallest balance first
Paying the balance with the highest rate first
Let's see what happens:
As expected, the best-case scenario occurs when the debt with the highest interest rate is paid off first. In this example, the difference between the best and worst cases is only $3.75, but its important to keep in mind that this is based on the one-month calculation for a relatively low balance of $1,700. The amount of interest owed becomes more important when calculated on larger balance over multiple months. The good news is that the math for those other cases stays the same, and this example will work for those as well.
There you have it! I hope this has helped you understand why paying the debt with the highest rate is the most effective way of paying down debt. If you have something similar that your would like explored, be sure to let us know at scalefinancialeductation@gmail.com!