Get Out of Debt

How to Pay off Credit Card Balances More Effectively

When it comes to paying off credit card bills, there are so many options and conflicting advice floating around it’s no wonder so many people make such expensive mistakes.

However, there are smart ways and dumb ways to repay your credit card debt. Taking the right approach, particularly when you have several credit cards to pay, requires a good strategy. It’s worth it though, because choosing the right approach can save you hundreds, if not thousands, of dollars in interest.

This simple approach, often called the Stacking method, will ensure you pay your credit card bills in the most effective way possible.

  1. Write out a realistic budget and work out what is the most you can afford to put toward paying off your credit card debt.
  2. Make minimum payments on all your credit cards.
  3. Check the interest rate charged section of your credit card statements and rank your credit card bills by interest rate. The interest charge calculation section is usually at the bottom of your credit card statement, under the list of transactions. (Federal Reserve)
  4. Pay the credit card bills with the highest interest rate independently of which balance is greater.

There are other ways to pay your credit card bills, but they are more expensive and take longer to repay. Here is why.

Penalty Interest Rates and Fees are Evil

If you’re drowning in credit card bills, it may be tempting to focus on one card at a time and forget about the rest. Bad idea.

Miss two consecutive minimum payments on your credit card and your card issuer can, and probably will, hike your interest rate to its penalty interest rate. The average interest rate on credit cards in 2014 was around 15%, while the average interest rate was around 28%.

Here’s another way to look at it. If you have a $1,000 on a credit card with a 15% rate and make payments of $25, it will take you 56 months (4 years and 8 months) to pay it back, and it will cost you $395 in interest. That’s bad enough, but miss a couple of payments and things get really crazy.

With a 28% penalty rate (and penalty rates are often higher) it will take you 118 months (9 years and 10 months) of minimum payments to repay the $1,000. By the time you finish, the total interest paid will be $1,935. A total of nearly $2,935 in credit card bills to repay a $1,000 loan.

Bottom line: Never miss a minimum payment on your credit card.

Focus on Interest Rates, not Balances

Some popular personal finance pundits like David Ramsey, encourage people to pay the credit cards with the smallest balances first for the psychological benefits of paying a credit card in full. Although this approach has its fair share of zealots, this is the method for people who are bad at math.

To illustrate, imagine you budget $300 every month to pay off your credit card debt and you have four credit cards with the following balances, interest rates and minimum payments.

Credit CardBalanceInterest RatesMinimum Payment

If you pay the credit cards with the lower balances first (Debt Snowball method) instead of targeting the credit cards with the highest interest rates, it will cost you nearly $450 in additional interest payments and you will be in debt for a month longer. Even though this example used modest amounts and similar interest rates, the savings are still considerable when you use the Stacking method. Savings are even more dramatic when you’re paying different types of debt, such as car loan payments, student loans, mortgages and credit cards, which can have interest rates ranging from 3% APR to 30% APR.

Another Method: Unite and Conquer

There is one other method that is potentially more effective than the Stacking approach. But it also requires you to have a good to excellent credit score. Here’s how it works.

Instead of paying off your credit cards individually, combine your credit card balances into one loan with a lower interest rate. This will allow you to pay your balance faster and save big in interest payments. There are two popular ways of consolidating debt:

1. Apply for a balance transfer credit card

Get a balance transfer card with a lower interest rate, preferably with a long 0% APR introductory period. Some cards will give you up to 12 or even 16 months of 0% APR, which gives you the chance of either completely paying or taking a big chunk out of your debt, without paying a cent in interest.

Be careful you don’t get blind-sighted by balance transfer fees, which can run between 3% and 5% of the balance transferred. If your credit is good you can qualify for some balance transfer cards that don’t carry a transfer fee.

2. Take out a home-equity loan

If you own a home and have equity on it, you can take out a home-equity loan to repay your credit card debt. Home equity loans usually have much lower interest rates and have the added benefit that the interest you do pay is tax-deductible.

To illustrate, if you have $7,000 in credit card debt, transfer it from an overall interest rate of 20% to a home equity loan of 6% APR, and pay off $300 a month, you’ll be debt-free three months earlier (25 instead of 28 months) and you’ll save yourself $866 in interest payments ($1,328 vs $462).

There is a big caveat you need to consider before consolidating your credit card debt with a home equity loan. By transferring your credit card debt to a home equity loan, you are converting an unsecured loan into a loan that is secured by your home. If you fail to pay your credit card, your credit score will suffer. If you fail to pay your home equity loan, you could lose your house.

Final Thoughts

Efficiency, time and money are not the only considerations when it comes to repaying debt. Developing good habits and morale are also important, which is why the Snowball method is so popular. If you think repaying a credit card in full is the small victory you need to build your determination to get debt-free, be my guest. Pick the card with the smallest balance, blow it out the water, and then go back to the Stacking method.

One final point to consider is the return on your investment when you pay off a high-interest credit card. If you have a 25% APR credit card and pay it off, it’s the same as if you put your money in an investment you could guarantee a 25% return. With an opportunity like that, you would be crazy not to put all the cash you could spare into it; right? As long as you are in debt, paying off the credit card with the highest interest rate is the safest and most lucrative investment you can possible make. How’s that for incentive?