There are two basic methods for paying off credit card debt (these can be used on paying off other debts too, but they're usually discussed as how to pay off credit card debt):
- Highest Rates First -- List all your credit cards, balances, and interest rates from highest to lowest ranked by interest rates. Make extra payments to the highest interest rate card (paying the minimum on the others) until it's paid off. Then go to the second-highest interest rate card, pay it off. Then the third-highest rate card and so on until they are all paid off. The advantage of this method is that it's the least costly -- you'll have the lowest interest expenses possible.
- Lowest Balances First -- List all your credit cards, balances, and interest rates from highest to lowest ranked by the outstanding balance on the card (the amount you owe.) Make extra payments to the lowest balance card (paying the minimum on the others) until it's paid off. Then go to the second-lowest balance card, pay it off. Then the third-lowest balance card and so on until they are all paid off. The advantage of this method is that you see progress faster and it keeps you motivated to continue the debt payoff plan. As one after another bill disappears, you get more and more positive reinforcement which in turn helps you to stick to your plan.
There are advocates for both of these methods and which is better is often confusing, even for money "experts" like Kiplinger's Personal Finance magazine. For instance, in Financial Planning for Newlyweds they recommend the following:
Start either with debt that has the highest interest rate -- usually credit cards -- or with accounts that have the lowest balances. That way you'll feel as if you're making progress. Once you've paid off one account, you can move on to the next.
Then again, they recommend a specific course of action in Tame Your Credit Card Debt as follows:
Credit card debt is costly. The average rate on a standard variable-rate card is nearly 15%, according to Bankrate.com, and it's not uncommon for young adults just starting out to pay even higher rates. You need to get rid of that debt as quickly as possible, so if you carry balances on multiple cards, focus on paying off the highest rate cards first while continuing to make the minimum payments on your other accounts. And this rule goes for your other debt too. If you have a credit card charging 15% interest and a student loan charging 6.8%, it makes the best financial sense to focus any extra payments toward your high-rate credit card.
So, which is better?
Personally, I think the highest rate first method is better if the person is disciplined and self-motivated. But let's face facts, most people with out-of-control credit card debt are not disciplined or self-motivated -- otherwise, they wouldn't find themselves in this situation. That's why I lean toward the lowest balances first method as being the better option for more people.
How about you -- which do you like best? Why?
When I was young and stupid, I used the lowest balance first method even though I knew the highest rate method was cheaper in the long run. The reason I did this was that it provided me with a sense of progress like you mentioned above, but it also provided me with more cash flow quicker so that I could apply that to the next card.
Now that I am older and wiser (and better paid), if I were to ever get into that kind of trouble again (doubtful), I would use the highest rate method because the cash flow would already be there.
Posted by: rdub | April 17, 2007 at 12:32 PM
When deciding which bills to pay off first, I'd consider the hassle factor and cost of making a payment. For example, the cost of a stamp effectively raises the annual interest rate on $100 by 4.68%. Plus having to keep track of whether you've made the payment.
So if I had a number of small debts I'd consider paying them off first just to save the aggravation of having to keep track of them and make the payments, and the cost of the stamps saved would also be a plus.
Posted by: EMF | April 17, 2007 at 02:04 PM
If you're worried about the cost of stamps, pay online. Nearly every credit card company out there allows you to pay via electronic funds transfer.
Or, use bill pay through your bank. Quite a few banks allow you to pay all bills, even those that don't accept EFT, through their billpay service for free, or perhaps a nominal fee (mine's totally free). This gives you the added convenience of having all your bills in one spot, and so you can see at a glance which bills are due when.
Posted by: Rick | April 17, 2007 at 02:47 PM
The way it worked out for us was that we paid off the highest interest rates first, but we did focus on paying off the smaller debts completely. We're down to three bills to pay each month now, and we believe we can have it all paid off within three years at most. It's a huge improvement from where we were before. We had the good fortune to have a change in financial perspective around the same time as we received several windfalls, otherwise we'd be just as deep in debt but driving a new car!
Posted by: bree | April 17, 2007 at 03:28 PM
When we were trying to decide which school loan to pay, the big higher rate loan or the smaller lower rate loan, we chose the smaller lower rate loan.
To make this decision, we created a spreadsheet showing the total cost of each method (vs. no early payoff) and the difference in total cost was $1000 or so over 12 years.
If we paid off the larger loan, we would save $1000, but it would have been 8 years before we realized the extra cash flow from paying the loan early. We chose to pay the smaller loan and not save the $1000 because it meant we realized the extra cash flow in 2 years.
With three kids, saving for retirement/college, etc., the extra cash flow has been very welcome - it's there if we need it and can do good things if we don't.
Posted by: Joey | April 17, 2007 at 03:47 PM
What about the third option of putting more towards the loan that costs you the most dollars in interest per month. So calculate the cost of each account based on the balance and interest rate, and then put the most towards the highest and the minimum towards the others. Repeat every month.
Posted by: Frank | April 17, 2007 at 04:25 PM
If your goal is just to pay off debt, then pay off the debt with the
highest rate.
If your goal is to increase monthly cash flow, then pay off individual
debts first.
If you're looking to buy a piece of property (for personal or investment
use) your debt to income ratio is what's important. This is a cash flow
measurement. It doesn't matter what the balance of your debt is. They
look at the required monthly payments relative to your income.
Say you've got a car payment at $200 per month and the balance is only
$2000. You've also got a credit card balance at $5000, but the monthly
minimum is $100 per month. You can improve your cash flow ratio or
you're total expenditure.
As always, it comes down to a case by case basis and what you're goal is
looking forward.
-limeade
Posted by: limeade | April 17, 2007 at 05:33 PM
There is a third payment method that you overlooked. Your credit score of utmost importance in getting cheap financing on housing, cars, student loans etc. Following a plan that improves your credit score may save you the most money in the end. Tens of thousands on a mortgage.
Your utilization ratio, i.e. The amount of your credit limit you are using is a big determinant in this.
So you should pay down your credit cards that are closer to being maxed our first. Once the ratio is down to 30-50% pay down the next card. When they are all that low then pay the highest interest first.
Posted by: Tdog | April 17, 2007 at 10:01 PM
I understand why poeple pay the lowest balance first - it's emotional attachment, and it's good for some people.
Myself? Highest rate first.
But now that I've read Tdog's comment, I understand the process better - fortunately my car disn't close to being maxed out.
Posted by: zen | April 18, 2007 at 11:51 AM
I think the real truth is that most people pay off their debts according to which debt collectors are hounding the hardest. Unfortunate, but true!
Posted by: Annette | April 26, 2007 at 07:05 AM
We just had this conversation at our house. Still debating!
Posted by: Stephanie | April 26, 2007 at 05:11 PM
I've paid off a significant amount of debt and 4 creditors using the lowest balance approach. It's worked the best for me, along with diligently moving all high interest debt to low interest debt over time.
Really, the thing that allowed me to start to get traction was getting interest rates knocked down first.
If I had to do it all again, I'd stick with the lowest balance approach. I have no regrets about it.
DB
Posted by: db | April 26, 2007 at 08:33 PM
P.S. -- I don't really care for the assessment that the high interest rate method is "better" but that the low balance method works for those with "no discipline or needing motivation."
I think the high interest rate has a mathematical edge, but the issue of finance isn't purely mathematical. It is also emotional and situational. So there is no real justification for trying to attach a value judgement to low balance vs. high interest rate.
For me, the low balance has worked so well because it's given me the ability to pay progressively higher amounts of money against a single debt at a faster rate, rather than thinly dividing payments among multiple balances.
I think the best thing anybody can do is pick whichever method you find most helpful, and just commit to it and stop worrying about which is "better". It's all about what gets the job done.
db
Posted by: db | April 26, 2007 at 08:40 PM
As an advisor I'm in favor of paying off high rate debt first because it's the most financially responsible thing to do. However there's a lot to be said for having to write fewer checks each month. Because of this, I usually recommend a blended approach.
If one of my clients has a couple of small balances that could be killed off within 3 months of payments I usually recommend they just focus on getting rid of those and then switch to paying off the highest rate debt. This way they get the best of both worlds. The get the satisfaction of being able to see some $0 balance statements but they didn't waste too much in interest by doing it.
It seems to always work out that the bill with the highest balance also has the highest rate. Funny how that works! :-)
Thanks for the great post!
pf101
Posted by: pf101 | April 27, 2007 at 01:20 AM
Roll all your balances onto 0% introductory rate credit cards. Pay off the lowest balance first. When the 0% term expires, roll them over again.
Posted by: Ryan | July 25, 2007 at 08:24 AM
Paying off the lowest balance cards is a good strategy. Once you have payed off the lowest balance card, you then have that payed off card's monthly payment which you can devote to the next low balance card and so forth...its a positive snowball effect. I think trying to pay the high interest rate cards could become daunting and not give a person the snowball of positive reinforcement to continue paying off all their debt. It would seem insurmountable, but that's just an opinion. Focusing on eliminating each debt is a good discipline. I'm trying to do that now myself, debt is never a fun thing, it's a handicap, but we create it ourselves.
Posted by: MC | August 04, 2007 at 06:01 AM