A Detailed Look at Credit Card Debt Settlement Theories

Much has been written about the best strategy for paying off your credit card debts. So you have a couple of cards, and are on a mission to pay them off as soon as possible, but where do you start? Obviously, the first priority should be to make the minimum monthly payment required on each credit card. Things get trickier when you have surplus cash that you want to use to pay off your cards quicker; most experts will recommend one of the following schools of thought:

  • allocate all surplus cash to pay off the card with the lowest balance first; and
  • prioritize paying off the card with the highest interest rate first.

What is the correct answer? Neither! The logic behind paying off the credit card with the lowest balance first is that you can quickly knock out the first card, and it will give you a sense of accomplishment and optimism to help you push forward eliminating your outstanding debt. The positive effects of this are quite limited, as the remaining outstanding debt, especially the credit card with the highest balance, will continue to weigh on you. Moreover, is this really your priority, to feel better about yourself? It shouldn’t be; the main goal should be to pay off ALL your credit card debt as soon as possible. This is what will really give you a sense of accomplishment and help you feel better about your financial prospects.

The second view, paying off the card with the highest interest rate first, has more merit. The goal should be to reduce the amount of interest you end up paying by the time all your debt is eliminated. This will in fact help you become debt free sooner. Keep in mind that in many cases, the card with the highest interest rate is the one with the highest outstanding balance as well (the interest charges are part of the reason the balance gets out of control). So allocating all surplus cash to this card definitely makes sense. However, where this theory is misguided is that it focuses on the interest rate, leaving out an important aspect, the actual balance on the card.

Paying off your credit card debt efficiently takes a mathematical approach. The focus shouldn’t be on paying off one card, rather, you need to consider all your credit cards as part of the bigger picture. Each month, your priority should be to pay off the credit card that is going to charge you the highest interest amount (in dollars as opposed to the APR). This means that from month to month, you will be using extra cash to pay off a different card. Let’s take a look at an example.

Say you have the following three credit cards:

Card

Outstanding Balance

Monthly Interest Rate

A

$100

1.0%

B

$200

1.5%

C

$300

2.0%

 

The minimum monthly payment on each is 3% of the outstanding balance. The total amount you will allocate each month to getting rid of your credit card debt is $50. So after paying the minimum payment on each, you have to decide where to allocate your surplus cash.

Credit card with the lowest balance:

According to this theory, you should pay off Card A first, followed by Card B then Card C.

Month

Card A

Card B

Card C

1

$100

$200

Min payment

$300

Min payment

2

$66

$197

Min payment

$297

Min payment

3

$31

$194

Min payment

$294

Min payment

4

$0

$186

$291

Min payment

5

 

$147

$288

Min payment

6

 

$107

$285

Min payment

7

 

$67

$282

Min payment

8

 

$26

$243

Min payment

9

 

$0

$186

10

   

$145

11

   

$101

12

   

$56

13

   

$10

14

   

$0

 

Credit card with the highest interest rate:

If you prioritize the highest interest rate cards first, then the order in which you allocate surplus cash would be Card C, Card B then Card A.

Month

Card A

Card B

Card C

1

$100

Min payment

$200

Min payment

$300

2

$98

Min payment

$197

Min payment

$265

3

$96

Min payment

$194

Min payment

$229

4

$94

Min payment

$191

Min payment

$192

5

$92

Min payment

$188

Min payment

$155

6

$90

Min payment

$185

Min payment

$116

7

$89

Min payment

$183

Min payment

$77

8

$87

Min payment

$180

Min payment

$37

9

$85

Min payment

$173

$0

10

$83

Min payment

$130

 

11

$82

Min payment

$88

 

12

$80

Min payment

$44

 

13

$78

$0

 

14

$34

   

15

$0

 

 

 

Credit card with the highest interest amount:

With this method, you compare credit cards each month, and allocate any extra cash to the one with the highest interest charges (outstanding balance multiplied by the monthly interest rate).

Month

Card A

Card B

Card C

1

$98

Min payment

$197

Min payment

$265

2

$96

Min payment

$194

Min payment

$229

3

$94

Min payment

$191

Min payment

$192

4

$92

Min payment

$188

Min payment

$155

5

$90

Min payment

$185

Min payment

$116

6

$89

Min payment

$144

$115

Min payment

7

$87

Min payment

$142

Min payment

$74

8

$85

Min payment

$99

$74

Min payment

9

$83

Min payment

$55

$73

Min payment

10

$82

Min payment

$55

Min payment

$29

11

$80

$9

Min payment

$28

Min payment

12

$33

$9

Min payment

$28

Min payment

13

$0

$9

$14

14

 

$0

$0

 

 

While you end up paying off all your debts in 14 months in the lowest balance method as well, the amount of interest you pay is less here. The results will vary depending on the combination of credit card interest rates and outstanding debt you have, but this method is based on math, and as such, will always be the most efficient way to pay off your credit card debts. 

Related articles:

The Right Way to Pay Off Multiple Credit Cards

Foolish Credit Card Mistakes You Should Avoid

How to Get Out of Debt On Your Own