What’s the best way to pay down credit card debt? LaTisha Styles, Millennial Finance Expert and Founder of Financial Success Media, LLC, outlines two popular strategies.
“In the first way,” says Styles, “you pay off the debts with the smallest balance. That’s how you get quick wins.” This is known as the “snowball” method, because the satisfaction of seeing a debt paid off, no matter how small, can produce positive momentum – like a snowball rolling down a hill.
“In the second way, you pay off the debt with the highest interest rate,” adds Styles. “It will take you longer to zero out that debt, but over the long run, it’s going to be cheaper.” This method reduces the overall interest charges that you will incur.
Both of these approaches are sound strategies for repaying credit cards, but a new study from the National Bureau of Economic Research (NBER) suggests that many consumers don’t follow either one. Instead, consumers tend to follow a balance-matching strategy – meaning that people tend to allocate their payments according to the size of the debt, without taking the interest rate into account.
Let’s look at a simple example. Assume you have $10,000 in total credit card debt with $5,000 on one card at 21% annual percentage rate (APR) interest, $3,000 on a second card at 27% APR, and $2,000 on a third card at 19% APR. You have $2,000 to apply to the debt. How would each approach apply?
The Snowball Method
Using the snowball method, you would pay the minimum on each of the first two cards and apply the rest to the third card. With this approach, the third card should be paid off within another month or two, depending on the available surplus in the coming months, and you would then address the debt on the second card in a similar fashion.
Note that you must not apply the available $2,000 and wipe out the third card’s debt while ignoring the other two. Failure to make at least the minimum monthly payment on the other two cards will result in penalty fees. Your credit score will be damaged by late payments, and you may also be hit with higher penalty interest rates that aggravate the debt problem.
The Highest-Interest Rate Method
In the highest-interest rate method, you would reverse the approach and make the minimum payment on the first and third card while putting all of the remaining debt toward the second card. In most cases, this will reduce the overall interest charges that you pay, putting your surplus to the most efficient use.
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