Most People Repaying Credit Cards Wrong: New Study Shows Most People Don't Use an Optimum Strategy
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.
To make the ultimate best use of your surplus, you would have to take both the interest rates and the balances into account. If one balance is much higher than the other and the interest rates are not far apart, the overall interest paid may be lower if you attack the higher balance.
All of these strategies assume a trade-off on fiscal discipline and psychology. If you have the fiscal discipline to apply it, the highest-interest rate method is clearly the best at reducing overall debt. If not, the snowball method works better than an even distribution of payment among all bills. A 2016 study in the Journal of Consumer Research backs that conclusion.
The NBER survey finds that a majority of credit card debtors simply tend to react based on the size of the balance of each card. A larger proportion of the payment is applied to the largest balance, regardless of whether it provides the lowest overall accumulation of interest or the best positive reinforcement on debt reduction efforts. Neither fiscal nor psychological optimization is considered at all. Using this approach in the above example, you would apply half of the payment ($1,000) to the first card, 30% of it ($600) to the second card, and 20% ($400) to the third card. You don't get the financial boost of the higher interest approach or the psychological boost of the snowball method.
What's the best debt reduction method for you? Only you can decide. From a standpoint of pure math, it's best to disperse payments to reduce the overall interest that you pay – usually by attacking the highest interest rate debt first. However, if you need a psychological boost to keep fiscal discipline by closing out any debt as soon as possible (snowball method) or seeing all of your balances decline across the board, that may be a fair trade.
Keep in mind that failing to use an interest reduction strategy can rack up significant waste. The NBER study found that the average household with two credit cards was paying an extra $90 in interest annually because of their payment allocation choices. With five cards, the excess interest charges hit $327 annually – and, for the top 10% of debtors in the study, poor payment allocation wasted over $1,000 annually in excess interest charges.
While there may still be debate on the best method to pay down credit card debt, there's no debate about one thing – none of these strategies will work if you don't have a surplus to apply to the debt. It's imperative to keep spending under control to have funds to apply to existing debt.
Once you get in the habit of spending less than you can afford to pay at the end of each month, financial planning becomes far easier. If you always pay off your credit card bill in full at the end of each billing cycle, there's no need for any other debt repayment strategy.
If you want to reduce your interest payments and lower your debt, try the free Debt Optimizer by MoneyTips.
This article was provided by our partners at moneytips.com.
