Debt Repayment: Pay Off Smallest Balance or Highest APR?
If you are paying hundreds or thousands of dollars each month in credit cards, auto loans, student loans and medical bills, you are not alone.
And if you are mentally or emotionally burdened by your debt, you are also not alone.
Debt is the leading cause of stress in American families.
If you’re ready to stop spending, tackle your debt and work towards financial freedom, there are a couple strategies to consider.
Compare the pros and cons of each before deciding on the best approach for you.
Two Popular Repayment Strategies
We'll evaluate the two methods: paying off your highest APR accounts first and paying off your lowest balances first.
For example, if you have a credit card with a $1,000 balance and a 13.99% APR, and a credit card with a $5,000 balance and a 29.99% “penalty APR”, which should you attack first?
For purposes of this article, we will assume, with your current monthly income, that you are able to make at least the minimum monthly payment on all balances.
If you are behind on payments or having to pay bills with credit cards just to stay afloat, you may need to look at consolidation, debt counseling, or possibly even bankruptcy.
Understand Your Debts
The first step of taking control of your finances is fulling understanding what you are working with.
Although this might seem daunting, or even depressing, it is important and necessary.
Get a blank notebook, a calculator, and your statements. Make four columns:
- The name and type of the account
- The balance
- The interest rate
- The minimum payment
- Bank of America / Credit card
- 13.99% APR
- $125 per month
Once you have listed all your debt, add up the minimum payments, and confirm that you have the monthly income to pay at least the minimum monthly payments without having to add to your already existing credit card debt.
To do this, you should have a general idea of other monthly expenses, such as car insurance, gas, internet and cable bill, water bill and utility bill.
Make a budget
This step is taking the information you’ve already gathered one step further, and planning how much you will pay on each bill, each month.
After you figure out how much you’ll have left over from all your minimum payments + your monthly living expenses, then you need to plan what to do with the extra funds you have.
Should you apply them to the lowest balance, or the account with the highest APR?
To stay on track with your plan, it is essential that you set realistic goals for yourself.
If you need additional money for travel or other non-essential activities, plan accordingly to set aside enough money.
If, six months into your paydown, you end up whipping out your credit card to fund a weekend vacation, the only person you’ll be hurting is yourself.
Like long-term weight loss plans, long-term debt payoff plans require strict discipline and accountability.
Paying Off Debts With the Highest APRs
Once you’ve identified all of the debt you have and the interest rate for each account, you can identify the account with the highest interest rate.
Is the payment on this the highest?
If you applied the “extra” money you have to work with each month, how long would it take you to pay this off?
What would your financial situation look like with this high APR debt completely eliminated?
Would you have more money to apply to the next debt?
Paying off accounts with your highest interest rates is the most economical approach. You will save the most money in the long run.
Paying Off Debts With the Lowest Balances
The strategy to pay off the lowest balance first is popular because it is the most empowering.
You will achieve success earlier, possibly even in several months.
This strategy ignores the interest rates of all of your accounts and focuses on what you can pay off the quickest.
Research has shown this method gives people an emotional boost from being able to quickly achieve success.
Once you have eliminated one debt, you can focus on the next lowest balance, until all debt is eliminated.
Picking Your Debt Repayment Approach
A Harvard Business Review study found that people paid off a credit card debt 15% faster when they paid off their credit card debt one at a time versus applying equal sums toward each different credit card debt.
For example, if you are making minimum payments on three credit cards, and you have $400 extra dollars extra each month to pay down debt, you are better off putting all $400 towards one account.
Although you will pay the least in interest if you attack your debt by chipping away at the accounts with the highest interest rates, this is not necessarily the best option.
Paying the smallest debts first might be costing you more money, particularly if you have high balances with high interest rates.
The decision may ultimately come down to which strategy you will be more successful at. For many, the lowest balance first strategy is the most effective.
Regardless of the strategy you choose, it is important that you do two things:
- Continue to pay at least the minimum payments on all accounts and
- Do not accrue more debt.
Some debt reduction experts will advise you to immediately cut up credit cards.
Closing your credit cards
While this is a good financial move, you should not close any accounts, unless the account has a hefty annual fee, such as some travel credit cards.
In this case, paying $500/year to keep a card open may be cost-prohibitive. If you must close your credit cards, try to keep your oldest accounts open to provide a lengthy credit history.
Closing a credit card account is bad for several reasons.
First, closing your account will affect the amount of available credit you have access to.
Secondly, account closure will also increase the percentage of credit card utilization you are using, which may lower your credit score.
And lastly, account closure will shorten the length of your oldest accounts.
For the best credit utilization ratio, you want to have the most credit available, but use the least. Having accounts open for many years shows you are a dependable borrower.
Choose your timing carefully. It is generally not advisable to close a credit card right before applying for a loan.
Consider Debt Consolidation
If at any point you’ve failed to make a minimum credit card payment, you’ll likely be paying a “penalty APR” which could be as high as 30%.
Depending on your balance, this could mean several hundred dollars in interest alone each month.
If you are in a situation where you have a high balance account with a high interest rate, it may be worth considering other options.
A personal loan may have a lower fixed rate than your current credit card APR.
If you do not have any installment debt, such as a car loan or student loan, adding a personal loan to your credit profile may actually improve your credit score, as your credit utilization will go down, and your credit mix will go up (both positive activity).
Balance transfer credit card
A popular alternative to a personal loan to consolidate your credit card debt is a balance transfer credit card.
Looking solely at the interest paid, a 0% balance transfer credit card will result in less money paid over time, especially if you are able to pay down all or a large amount of debt during the promotional period.
Rather than paying interest, you’ll be paying principal.
This does not mean, sign up for the first balance transfer credit card offer you receive in the mail.
If you are utilizing most or all of your revolving credit, in other words, your credit cards are maxed out, your credit score may also be suffering, along with the financial strain of covering your monthly payments.
One important thing to remember: This is another credit card.
Many balance transfer offers include 0% introductory rates to pay down your credit score within a certain promotional period.
Be careful though, many of these offers contain fine print and balance transfer fees (3% is common).
The Bottom Line
No matter which debt reduction strategy you adhere to, the important thing is that you are consistently paying down debt, and not accruing more.
It is easy to be discouraged, especially when a financial goal will take many years.
Stay positive and focused on your goals, and remember that with focus and determination, your situation can improve drastically over time.