Q: Hey CreditCardGuru, I have around $5,400 spread across 4 different credit cards and am working tirelessly to pay them down. How can I figure out which credit card I should pay off first?
Pay the highest rate balances first.
But not everyone agrees with me. Dave Ramsey says this:
Pay off the smallest debt first to create the greatest momentum in your debt snowball.
Ramsey believes that paying off the smaller debts first will motivate you more to pay off the bigger debts. With all due respect to the great Mr. Ramsey, I think this piece of advice is utterly ridiculous.
If your goal is to pay down your credit card debt in the quickest amount of time possible, how can that be accomplished if high interest rates are causing it to keep growing? Don’t you remember, Mr. Ramsey, that is where the phrases “debt cycle” and “debt snowball” originate from – seemingly never-ending debt because the newly accrued interest charges mostly offset your payments?
Where it gets complicated…
Start with the highest rate credit card first and knock that out, next go after the second highest rate card, and so on. Seems simple enough, right?
Well unfortunately, there’s something else you need to consider when choosing which credit card to pay off first:
Credit Utilization Rate (CUR)
This term refers to the percentage of your credit limit being used on a given card. For example, if you have a credit card with a $10,000 limit and a $4,000 balance, that would be a 40% CUR. The reason I bring this up is because having a high CUR can negatively impact your FICO score, even if the high balance is only on one card and the others have $0 on them.
According to MyFICO (an official FICO website) using 10% or more of your credit limit might adversely affect your score. That being said, most personal finance pundits claim it’s okay to use up to 30% of your credit limit, because the impact on your score between 10% and 30% is trivial.
Now I know what you’re thinking “My credit limit isn’t big enough to stay below 30%!” Well that’s the reason I’m talking about it! Are you using 50%, 60%, 70% or even higher on an account? If so, you may want to give some extra priority to paying it down, even if its interest rate is not the highest.
Once your CUR on a card starts going past 50%, banks usually start viewing you as a higher risk (like you’re at the end of your rope with credit). Many forum posters have reported their credit limits being slashed to the amount of their balance, when they start hitting utilization in the 60’s and 70’s.
But sometimes even when you do have a high CUR on one or more cards, the credit card to pay off first still remains the one with the highest rate. If you aren’t planning on taking out any mortgages or loans within the next couple years, then maybe the credit score ding you get from the high CUR is worth it, if it means you will be saving money on interest by paying the highest rate card. Ultimately, you will have to weigh the pros and cons to decide for yourself.
Use 0% offers as long as they won’t encourage debt
As I stated above, the less interest you are charged then the quicker your debt will be paid off.
However for some people, 0% credit card deals encourage them to spend more. As long as you’re not one of them, then I would highly recommend shifting your highest rate balances to a 0% balance transfer offer.
After you do that, the rule for which credit card to pay first will remain the same: Pay the highest rate balances first. Since the 0% offers won’t be bearing interest, you can make minimum payments on them, while focusing on the next highest rate cards you have remaining.