Monday, December 10, 2012

Smallest Balance or Highest Rate - Which Credit Card Should You ...

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The following post is by MPFJ staff writer,?Kevin Mercadante, who is professional personal finance blogger, and the owner of his own personal finance blog,?OutOfYourRut.com. He has backgrounds in both accounting and the mortgage industry.

If you only have one or two credit cards with balances, this question is really no big deal. But if, like a lot of people, you have several cards with balances, this can be a real issue. You're not only looking for the best way to pay off your credit cards, you?re also looking to do it in a way that will motivate you to see the process all the way through to the end.

Which method you choose is really more a matter of personal comfort level. The really important issue is that you set a plan to pay off your credit cards, get STARTED and stick to it.

The case for paying off the smallest balance first

Paying off the smallest balance first was made popular by Dave Ramsey's credit card "snowball" technique. The idea is that, if you have several credit cards that you need to payoff, you start off with the smallest one first. The logic is that the smallest balance will be the easiest one to payoff. Once that card is gone, you move up to the next smallest balance, but you have more confidence and it will be easier to accomplish because one of your credit cards is already gone.

The attraction of this method is that it's probably the best way to see results quickly and will give you a "quick psychological win." You're not concentrating on the amount of debt you have outstanding at this point, you're really employing a divide and conquer strategy. If you have six credit cards with outstanding balances, and can knock out the smallest one in the first month, right there you?re down to just five cards. That's progress you can easily see, and that helps with motivation.

It doesn't hurt either that with the disappearance of the smallest balance, the monthly payment goes away too. By applying the amount for the payment to your next smallest card you should be able get rid of that one quicker than expected too.

As a method of paying off credit card debt, this strategy is hard to beat. It?s kind of like knocking out your credit cards domino style.

If it has a downside, it's that often by paying off the smallest balance you hardly make a dent in the total amount of debt you have. But, this method is more about psychology than dollars and cents.

The case for paying off the highest rate first

From a pure financial standpoint, paying off the cards with the highest rate makes the most sense. Interest is a pure expense, and by going after the high rate cards first, you?re doing a better job of reducing the actual expense, if not the overall monthly payment.

If you payoff smaller balances with lower interest rates before paying off the higher rate cards, you're actually allowing your interest expense to accumulate.

As you payoff the higher interest rate cards first, you're ensuring that more of your monthly payment will go to principal repayment. Ultimately, that should enable you to pay off all of your credit cards more quickly.

This method has a downside too. Since high interest rates consume more of your monthly payment it will be more difficult to payoff a single high interest rate card. You won't see as much progress with this method, especially early on.

And then, Plan C - payoff the card with the highest payment

Let's add a wrinkle to the mix; let?s add still another method. Let's say that the best credit card payoff strategy might be to first concentrate on the credit card with the highest monthly payment. This method has at least two significant advantages.

Generally speaking, the credit card with the highest monthly payment is also the one that is most threatening to your budget. By eliminating this card first, you will be removing the largest payment from your budget. That will have an important psychological effect ? you will see the most immediate benefit to your cash flow once the card is gone.

The second major advantage, and probably the bigger of the two, is that once the card with the biggest monthly payment is paid off, you will free up the largest amount of money to concentrate on paying off your other cards.

There is a downside to this method as well. It's a very likely that the card with the highest monthly payment also has the highest total balance. If that's the case it will take a long time just to payoff a single card.

One way to counterbalance this would be to match payments versus card balances. For example, if you have a credit card that has a balance of $3,000 and a monthly payment of $100, you may want to payoff that card before tackling one with a $5,000 balance and $100 monthly payment. The card with the smaller balance will go away faster.

The important thing is to start paying your credit cards off

As you can see, there are various ways to payoff credit cards, no matter how many you need to payoff or what the balances are.

Choose the method that will most motivate you to finish the job. If eliminating the number of cards you have balances on appeals you, then begin by paying off the smallest one first. If the size of the payment is biggest concern, concentrate on the card and biggest payment. If it's interest rate then start with the card with the rate that?s the highest.

Also, you don't have to use a single strategy. You could for example, choose to payoff the card with the highest monthly payment first. Once that's done, you can shift to paying off the smallest balances first.

The most important consideration is finding the method that will make it easiest for you to make your credit card balances go away.

How about you all??Have you used any of these strategies to payoff your credit cards? Which would you recommend?

***Photo courtesy of?http://www.flickr.com/photos/dno1967b/6426867439/

Source: http://www.mypersonalfinancejourney.com/2012/12/smallest-balance-or-highest-rate-credit-card-prioritization.html

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