Financial Thoughts – Credit Cards (and other debt)

We all have them and probably have a love/hate relationship with them. A credit card can be a very useful tool, but it can also be a very destructive enemy. If you carry a balance on one or more cards, there is a recommended method to paying them off that will optimize the impact of your money. It is this: pay your credit cards off in order of highest to lowest interest rate, regardless of balance.

Let's say you have the following situation with 2 cards:

• $1,000 at 6%
• $2,000 at 12%

Now, the $1,000 amount would be faster to pay off. But it would actually cost you more! How so? Let's take this example, make an extreme payment of $1,000 per month, and see what the difference is for both options. Let's pretend the interest does not compound to make this simple, although normally it would, which will make the difference even more.

If we paid the $1,000 note off first, we will accrue $30 of interest from the second note across the 3 month period (assuming no compound interest). Note we pay the lower one off, thus not accruing any interest, while the larger card accrues $20 of interest. Then we pay two $1,000 payments across the next two months, dropping the interest, and then finish paying the $30 interest we have accrued the final month.

If we pay the second one off first (the higher interest rate), we will make two payments of $1,000, accruing $10 of interest on the larger note and $10.05 on the smaller one, and then we finish off with the remaining payments.

I want to emphasize that this is a very simple example that does not take compound interest in effect. But you can see that the difference is $9.95 in interest. With larger amounts, higher interest rates, and more credit cards, this amount saved could be significant.

The other thing about paying off credit cards, student loans, cars, etc. is to take into consideration how much you make in a high interest savings account. Usually student loans are lower than what you can earn in a savings account like ING Direct offers. Thus, it may not be the best option for you to pay off your student loans, unless there is a time limit or the interest rate is increasing. Likewise, if you have a no payments, no interest plan, it may be better to save the money and pay it off in one lump sum and earn interest in your savings account while you save it. This is practical only if you are financially disciplined enough not to spend that amount, which I am not really very good at either.

I encourage you to sit down and look at what you have outstanding to pay off and create a payment plan to maximize your money's effectiveness.