How to pay off credit card debt

Kim writes in:

My dad told me that the best way to pay off a credit card is to pay it all off at once so I have been saving up the money to do that. My boyfriend argues with that saying that the best way to do it is to make the biggest possible payment each month. Who is right?

Your boyfriend’s plan is better in a very straightforward sense. I think your dad is also bringing a good concept to the table, too.

If you look at nothing but the debt, the best way to pay off that debt with the minimum total interest payments for you is to pay it off with the largest payments you can throw at it each month. 

Let me give you an example. Let’s say you owe $1,000 and that it’s compounding at a rate of 2% per month (which would be roughly a 25% annual interest rate). Let’s also say that the minimum payment is $25 and that each month, you’re capable of putting $200 toward that debt each month.

Now, let’s follow your father’s plan.

After the first month, you’ve paid the $25 minimum payment and put $175 in the bank. The starting balance was $1,000 and 2% interest was charged – $20. Your $25 covers the $20 in interest and knocks $5 off of the balance, bringing the ending balance down to $995. Your bank account has $175 in it.

After the second month, you’ve paid the $25 minimum payment and put $175 more in the bank, raising your account balance to $350. The starting balance was $995 and 2% interest was charged – $19.90. Your $25 covers the $19.90 in interest and knocks $5.10 off of the balance, bringing the ending balance down to $989.90. Your bank account has $350 in it.

After the third month, you’ve paid the $25 minimum payment and put $175 more in the bank, raising your account balance to $525. The starting balance was $989.90 and 2% interest was charged – $19.80. Your $25 covers the $19.80 in interest and knocks $5.20 off of the balance, bringing the ending balance down to $984.70. Your bank account has $525 in it.

After the fourth month, you’ve paid the $25 minimum payment and put $175 more in the bank, raising your account balance to $700. The starting balance was $984.70 and 2% interest was charged – $19.69. Your $25 covers the $19.69 in interest and knocks $5.31 off of the balance, bringing the ending balance down to $979.39. Your bank account has $700 in it.

After the fifth month, you’ve paid the $25 minimum payment and put $175 more in the bank, raising your account balance to $875. The starting balance was $979.39 and 2% interest was charged – $19.59. Your $25 covers the $19.59 in interest and knocks $5.41 off of the balance, bringing the ending balance down to $973.98. Your bank account has $875 in it.

After the sixth month, your starting balance of $973.98 is charged 2% interest, equaling $19.48 and bringing your balance to $993.46. You apply that $875 saved to that balance along with an extra $118.54 to pay it off.

All told, under your father’s plan, you will have paid $1,118.54 to pay off the loan. Now, what about your boyfriend’s plan?

After the first month, you’ve paid $200 directly to the credit card company. The starting balance was $1,000 and 2% interest was charged – $20. Your $20 covers the $20 in interest and knocks $180 off of the balance, bringing the ending balance down to $820.

After the second month, you’ve paid $200 directly to the credit card company. The starting balance was $820 and 2% interest was charged – $16.40. Your $200 covers the $16.40 in interest and knocks $183.60 off of the balance, bringing the ending balance down to $636.40.

After the third month, you’ve paid $200 directly to the credit card company. The starting balance was $636.40 and 2% interest was charged – $12.73. Your $25 covers the $12.73 in interest and knocks $187.27 off of the balance, bringing the ending balance down to $449.13.

After the fourth month, you’ve paid $200 directly to the credit card company. The starting balance was $449.13 and 2% interest was charged – $8.98. Your $25 covers the $8.98 in interest and knocks $191.02 off of the balance, bringing the ending balance down to $258.11.

After the fifth month, you’ve paid $200 directly to the credit card company. The starting balance was $258.11 and 2% interest was charged – $5.16. Your $25 covers the $5.16 in interest and knocks $194.84 off of the balance, bringing the ending balance down to $63.27.

After the sixth month, your starting balance of $63.27 is charged 2% interest, equaling $1.27 and bringing your balance to $64.54. You pay it off in full.

All told, under your boyfriend’s plan, you will have paid $1,064.54 to pay off the loan. This is $54 less expensive than your father’s plan.

The principle is very clear: in terms of maximizing every dime in a perfect environment, you’re better off making big payments on the debt than holding cash back for a big payment at the end.

So, what benefit is there to your father’s plan, then? The benefit appears when you recognize that your life is not a perfect environment.

If you do not have any cash in the bank and something unexpected happens in your life, like the transmission in your car failing or your grandmother passing away, you’ll find yourself in a situation needing more cash than what you have and your response to that will be to add to your credit card balance.

Of course, you might just think that having a credit card with some of the balance paid off will serve your needs, as you can just use that credit card. The problem with that scenario is you’re trusting that the bank won’t lower your credit limit. That’s a tactic many banks use if they see someone who is a potential risk at their current credit limit. If they lower that limit, then you’re really in a bind.

Cash is the most secure emergency fund. You’re not relying on a bank extending credit to you for your emergency protection purposes.

Given that, is your father’s plan better than your boyfriend’s plan? It really depends on what the rest of your life looks like. Do you already have an emergency fund? If so, then your boyfriend’s plan is a better one. Do you have lots of avenues of risk in your life, such as a car that you need for a daily commute? If so, then your father’s plan is better because of the security it provides.

This is one of those situations where personal finance really is personal. If you assume a perfect life, your boyfriend’s repayment plan is best. The question is how perfect will your life be during the period of repaying that debt.

The post Examining Two Credit Card Repayment Strategies appeared first on The Simple Dollar.