New Year, New You—How to Escape Debt
When confronted with credit card debt, British researchers found that individuals make equal payments on all of their credit cards. While this study focused on consumers in the U.K., the authors pointed to a study with similar findings in Mexico, which indicates this behavior could cross borders.
Making equal payments on multiple cards is going to cost more money in the long run. Since you are spreading your payments across several cards, you will make lower payments toward each balance. This will accrue more interest charges since it will take you longer to pay off the balances.
How should you escape credit card debt? You usually want to pay off the card with the highest interest rate first, as this will save you money. Make the minimum payments on all of your other cards and put any extra money toward paying off the credit card with the highest interest rate.
Let’s say you have two credit cards with the same balances: $5,000 (for a total of $10,000 in debt). One credit card has an interest rate of 15.9%, but the other has a rate of 20.49%. In addition, you have set aside $500 in your monthly budget to tackle this debt.
In the first scenario, you pay an equal amount on both credit cards: $250. In this case, you will pay a total of $848 in interest on the 15.9% card, and it will take you 24 months to pay off that card. On the higher interest card, you will pay $1,170 in interest and it will take you 25 months to pay off the debt. In total, you will pay $2,018 in interest.
But there are some savings if you make larger payments on the high interest card. Make just the minimum payment on the lower interest rate card (which would be about $150) and put the other $350 on your high interest card. In this scenario, you will end up paying off the higher interest rate card in 17 months and pay only $781 in interest. After that time, you can put the full $500 towards your lower interest rate card. You will still pay off the card in 24 months, but you will pay $1,135 in interest. In total, you will pay $1,916 in interest.
While you will only be saving just over $100 in interest in the second scenario, you will have the satisfaction of paying off a credit card a full eight months faster than expected. Additionally, the savings are even greater if there is a wider gap between interest rates. An online calculator can help determine how much you can save.
There is one exception to the rule of paying off the card with the higher interest rate first, and that is when you owe a relatively small amount on one card. In the example above, if you only owed $1,000 on the card with the lower interest rate, it would be smarter to pay off that card first. The good feeling from knocking out one debt may spur you on to pay off the other debt.