So my Dad and I were discussing credit card stuff (he’s in the business). He made a very important point which I haven’t heard discussed much. So here’s my public service announcement:
The credit card company will pay off your lowest interest balance first with the money you send in. This is guaranteed to cost you money. The amount depends on your balance and percentages.
An example. Suppose Mr. Micah and I had $5000 of debt at 30% APR. Now, we called the company and they agreed to lower our APR to 13%. But this APR would only count towards new purchases (they don’t always say this part, so be sure to check with them. it’s hidden in the fine print). Now we go out and spend $1500 on a couch. Dining room set? Flat screen tv? I can’t imagine spending $1500 for anything but an entire month’s expenses, so this is a stretch.
We send in $250 to start our debt snowball. The $250 will be applied to our $1500 purchase, not our $5000 of old debt. So the $5000 will continue to accumulate interest at the old rate.
If we pay off $250 every month, we’ll eventually pay off the whole thing. But we will have paid more money total (because of the higher APR) than if we’d gotten them to apply our payments to the balance with the higher APR. In this case, $369 more would go to the CC company.
So find out how your CC company will let you pay off the higher-interest balance first. Maybe it’s as simple as writing on the check line, “apply to higher-interest debt.” But call them. Don’t assume. A simple call to their service people should help you find out the exact protocals of your company.
Even if the service people annoy you, do it. Avoiding this call will cost you in the long run (especially if you always carry a balance, since it’s guaranteed to be at the higher rate!). Make the call today.
(note, here’s a link to the spreadsheet I used for my calculations. 30% APY means 2.5% per month. 13% means 1.08% per month. We assume that you begin with sending in $250 right away. Good job! Please let me know if you have any methodology questions.)
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This is why some people criticize Ramsey’s debt snowball idea. After all, if they were on separate cards, he’d recommend paying down the $1500 balance first (since it’s smaller). I think Ramsey would reply A) that your example is a bit extreme since it’s got a 17% gap between the two balances, which isn’t going to happen terribly often in real life, B) $369 isn’t a very lot of money in the end (it’s about 6% of the entire debt), and C) paying off those small debts has an important psychological reinforcement effect (which doesn’t really apply in the example you gave, since you’re not going to consider either debt paid off until both are). I do not mean to imply that Ramsey wouldn’t give the same advice that you do – I’m sure he would, but he does give contrary advice in analogous situations.
Personally, I don’t think much of the debt snowball idea. I think paying off the highest interest rate first is the way to go, but a lot of people swear by it even though it doesn’t make mathematical sense (correctly pointing out that personal finance is more about psychology than mathematics).
I think the psychology of the debt snowball depends on the person. For those of us who get our little brains fixated on math, spreadsheets, and the like, paying it off by interest rate make sense. For those with fewer math skills I can see how the other might be psychologically easier.
In this case, of course, someone else is arranging the details of the snowball, which is why it can be easy to forget…
I’m with you, Mrs. Micah. I can remember when $369 was a lot of money to me. Actually, although I make a fairly good living now, it’s STILL a lot of money to me, even if its just psychological.
That’s almost two weeks take home pay when you are close to minimum wage or a whole week’s worth at double minimum wage. It’s also the equivalent of over a whole year’s worth of your current alternative income goals met.
If you are focused on both squeezing every penny out of your budget that you possibly can and focused on reducing your debt, go for it. I don’t think psychology is going to trip you up at all.
Interesting post, I had no idea of this concept. Calling or writing the CC company seems like a must do!
Agh! This is such a dirty dirty trick. I’m so glad that my husband and I don’t have any credit cards anymore! If only no interest ever existed! Here’s to good luck for you getting rid of these punks that are getting all your interest money, Mrs. Micah.
Brooke, we should all be thankful that interest exists. Without it, nobody would have any incentive to invest in the future. In general, I’m in favor of earning it, rather than paying it. (I do pay 2.6% on my student loan. I could afford to pay it off right now, but my most conservative investment, my savings account, is still paying 4.75%, so it doesn’t make a lot of sense to do so.)
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