Across the web you find a lot of people talking about whether you should pay off the higher interest rate credit card first or use the Snowball Method and pay of the smallest balance first and then the next smallest so you can feel the accomplishment of paying off a credit card. Well what is the cost and benefit of each approach?
After you have done all the things I mentioned in a previous post about paying off your credit cards, you need to be thinking about what method you will undertake to pay off the remainder of your credit card debt. The Higher Interest Rate Method or the Snowball Method? I am not going to make you wait till the very end to tell you what I think is the right move, paying high interest rate cards first is the obviously better move, and I will explain why.
The Higher Interest Rate method is self explanatory, pay off the balance on the higher interest rate card first, you save yourself $ in interest, and because of that savings you will save yourself months and maybe even years in payments.
Now on to the Snowball Method. You have 3 credit cards:
CC1 – $5,000 @ 18%
CC2 – $3,500 @ 22%
CC3 – $1,200 @ 15%
The snowball method says you begin by paying off the CC3, get that card out of the way so you can feel the accomplishment of having one less credit card bill. Now lets look at those same 3 credit cards but also include the interest accumulating on them.
CC1 – $5,000 @ 18% ($900 in interest per year)
CC2 – $3,500 @ 22% ($770 in interest per year)
CC3 – $1,200 @ 15% ($180 in interest per year)
For a total of $1,850 in interest per year.
Now this is simplified because you are paying down these cards so the interest is less than what I have listed, but the example is for illustrative purposes. Because you paid down CC3, you saved yourself $180 in interest going forward. If you had used that same $1,200 to pay CC2 (3,500-1,200)*.22 = $506 is the amount of interest you would have going forward, not $770. By choosing to pay down the higher interest card instead of the lower balance card you would have save on interest $770-$506=$264 vs the $180 by paying off CC3. That is a difference of $84!
If you need gold stars to get through your financial journey, then choose the snowball method, but if you are serious about getting out of debt and on your way to financial freedom, you need to be paying off the higher interest rate loans first. PERIOD.