Why should I pay off high interest rate credit cards first?

September 12, 2010

You’ve probably read that you should pay off high interest rate credit card debt first. From a financial standpoint, that’s true. It costs more to carry a balance on a high interest rate credit card. The longer you take to pay off the card, the more money it costs you. Paying off high interest rate debt saves you money and usually lets you pay off the debt faster.
Here’s an example to demonstrate:

Let’s say you have two credit cards.

1.Credit Card A has a $3,000 balance and a 22% interest rate.
2.Credit Card B has a $1,500 balance and a 12% interest rate.
Let’s also assume you can spend $150 a month toward these debts. If you pay off Credit Card A first, you’d pay a total of $1283 in interest and it would take 39 months to become debt free. On the other hand, if you paid off Credit Card B first, you’d pay a total of $1764 in interest and it would take you 42 months to become debt free.

Paying off the high interest rate debt saves you $481 in interest and you’ll pay off the debt 3 months sooner.

Notice I said paying high interest rate debt makes sense from a financial standpoint. Dave Ramsey, millionaire-gone-bankrupt-turned-millionaire, suggests paying off smaller debts first regardless of interest rate. He argues that when small debts are paid off sooner, you remain motivated to pay off the next debt and the next, until you’re debt free.

It’s true that the smallest-balance-first method let’s you pay off some debts sooner in the beginning. In our example above, under the highest-interest-rate-first method, you’d have the first card paid off in 31 months. Under the smallest balance first method, you’d have the first card paid off in 14 months. But remember, it takes you longer to pay off the debt completely under the smallest-debt-first method.

When you’re ready to pay off your debts you have to decide if you need the motivation from paying off smaller debts at the expense of spending more money on interest.

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