Paying Off Credit Cards Intelligently

Over the past fifteen years, various debt professional gurus have risen and attempted to challenge the obvious that, if you have debt, you should attempt to pay off the highest interest rate obligations first.

Some of these professionals have focused on the amount of each debt obligation, and then argued that consumers should pay off each debt obligation with the lowest principal balance first and then address those obligations with higher interest rates.

I appreciate and applaud the nod towards behavior economics that that this advice incorporates. It recognizes that, if someone is receiving five different bill requests each month, it can be daunting to identify progress and therefore there may be a higher likelihood of declaring for bankruptcy or otherwise making one’s financial situation worse.

At least if someone uses available surplus to knock out the low-balance $3,000 debt, the month thereafter will only involve receiving invoices from four different lenders and a sense of progress can be ascertained, momentum felt, and even more rigor applied towards the debt payment.

This type of psychologically satisfying approach may be prudent if the interest rate on the various debt obligations are close to each other—if everything is within a 8-10% interest rate range, then sure, it can make sense to follow a debt repayment strategy that extinguishes a particular obligation with a lender every few months.

But if there is a three point or greater spread in the debt obligation, it is absolutely in your best to get over the psychological preferences and pay off the high interest debt first. I compared a person with a  $25,000 loan and a $50,000 loan at 8% and 18% interest rates over a seven-year period, assumed ran separate calculations on what to do with a surplus $500 per month that can be applied toward either. The person who chooses to pay off the lower interest rate loan first is taking on an additional $28,500 in additional payments simply as a result of the order in which they tackled the debt.

If the person in this debt situation is making $20 per hour, this is 1,425 extra hours simply resulting from the manner in which they choose to make repayment. And, as insane sounding as those numbers are, it is even more extreme if the $20 per hour assumption is pre-tax rather than post-tax income.  This discrepancy is so extreme that it would constitute financial self-destruction and malpractice to pay off the low interest debt first.

A lot of times, you hear things on the radio repeatedly that get repeated as the advice of the moment and nod your head along, assuming it can’t be that bad because you hear it so frequently. This is not true when it comes to debt repayment advice that advocates a balance-oriented rather than interest-rate oriented approach to debt servicing.

If everything is within a few interest rate points of each other, I still strongly recommend paying off the highest debt interest first because it will require a lower cumulative amount of lifetime payments and will lower the portion of your life’s income that is shipped off to benefit the shareholders of lenders. But if the interest rates are close, I can at least tolerate someone who prefers the psychological high of knocking out individual balance obligations along the way.

When there is a meaningful interest spread of three points or more, I can no longer tolerate the psychological preference. If it means that much to you, you should make payments on time for a few months, get your credit score up, and then consolidate your debt somewhere into one balance. And, if you can’t do that, make an excel spreadsheet treating all your separate debt obligations as one item and then actually apportion the payments in favor of the highest interest obligation when you actually make your payment.

But I cannot stand the debt payment approach that advocates knocking out lower balances first, especially when the larger balances carry an interest rate that is more than three points higher than the lower balances. The amount of extra time it needlessly tacks onto the extinguishment of the debt is so extreme that the advice should be discarded. I don’t like these pyramids and snowballs they have become fashionable because it results in more cumulative money being spent, often by people least in a position to do so. It should become an automatic impulse that, if you have any debt, the highest interest obligation should be paid off first. It is a law mathematics, and creative and gimmicky alternatives should be ignored.

2+2=4. That cannot be improved upon with any innovation, and by definition, any change would be worse.