Dear Liz: I’m confused about paying down credit card debt. Some say to pay the lowest-balance cards first and others say the highest balance or the one with the highest interest. I have almost $16,000 on credit cards ranging from a $4,930 balance on a card with an 8.24% interest rate to $660 on a card with an 18% rate.
Answer: Actually, the first question you should ask is “How much credit card debt do I have compared to my income?” If your balances equal half or more of your annual earnings, you may not be able to pay it all off. You should make appointments with a legitimate credit counselor (such as one affiliated with the National Foundation for Credit Counseling at http://www.nfcc.org) and a bankruptcy attorney (referrals from the National Assn. of Consumer Bankruptcy Attorneys at http://www.nacba.org).
If your situation isn’t that dire, the fastest way out of debt is to pay the minimums on your lower-rate cards and send as much money as possible to your highest-rate card. Once that’s paid off, concentrate on paying off the next-highest-rate card, and so on. Some people instead like to target balances from smallest to largest to get a quicker feeling of victory, but you typically pay more in interest with that approach.
Maybe I’m cynical, but the whole “which debt to pay off first” debate always seemed like a red herring that certain personal finance media personalities (not talking about you, Liz) use to keep their names in the headlines without saying anything that’s actually useful. If you’re even worried about which debts to pay off first, you’ve already done the hardest part, which is restructuring your budget from one where the debt balances are going up to one where they’re going down.
It’s true that you’ll pay more in interest if you pay off a high-rate debt before a low-rate debt. But unless any of your debts have truly astronomical interest rates (e.g., payday loans) or unless you’re paying only a little more than the minimum payments (in which case I echo Liz’s advice to schedule meetings with credit and bankruptcy professionals), it’s not going to make that big of a difference.
If you really must have someone to tell you which debt to pay off first, I like the advice that Warren and Tyagi give in “All Your Worth”: Pay the debt first that bothers you the most.
Whoops – I meant to say that “It’s true that you’ll pay more in interest if you pay off a LOW-rate debt before a HIGH-rate debt.”
I’d suggest Johanna be careful what she advises… “pay the debt first that bothers you the most” is the worst advice I’ve ever heard, even if it’s someone else’s quote. If you can afford to pay more than minimums you must target high interest rate debt first, just as Liz recommended. It’s the only way to get out of the debt trap. To suggest using your heart before your head (ie: paying the debt that has more emotion tied to it before the one that costs you more) is foolhardy.
There is a great site called Ready for Zero that is free and helps you do just that. You put in the amount, APR, etc. of all of your cards, and then what you’re willing to spend per month to pay them off, and it gives you the best strategy. That simple.
Credit-card minimum payments are calculated so that they always (as far as I know) cover at least the interest that has accrued that month. So if you’re covering at least the minimums on all your debts (and not adding new charges to any of them), then your balances will go down and you will get out of debt eventually. So no, you won’t get stuck in a “debt trap” by paying down a low-interest debt before a high-interest one.
Also, emotions can be important. One of the examples Warren and Tyagi give for “the debt that bothers you the most” is a loan taken from a relative – there might be a good reason to pay that down before a higher-interest credit card, even though it means paying more in interest in the long run. Some things are more important than money.