I'm receiving a $4,000 gift. I'm going to put $1,000 in an account.
Next - with this gift I can pay off a credit card with a 23% APR or I can make a 15% dent in a 26% APR credit card.
Do I pay off the 23% or make the dent in the 26%? Considering both are a high interest rate.
Every $1,000 you use to pay off a 26% interest rate card saves you $260 / year.
Every $1,000 you use to pay off a 23% interest rate card saves you $230 / year.
Every $1,000 you put in a savings account earning ~0.5% interest earns you $5 / year.
Having cash on hand is good in case of emergencies, but typically if your debt is on high interest credit cards, you should consider paying off as much of it as possible. In your case you may want to keep only some small amount (maybe $500, maybe $1000, maybe $100) in cash for emergencies.
Paying off your high interest debt should be a top priority for you. You may want to look on this site for help with budgeting, also. Typically, being in debt to credit card companies is a sign of living beyond your means. It costs you a lot of money in the long run.
If it were me, I would pay off the 23%er. That is as long as you don't borrow anymore. Please consider "your hair on fire" and get that 26%er paid off as soon as possible.
From my calculations your big CC is sitting at 26% has a balance of 20K. Holy cow girl, what in the world? The goal here is to have that paid off in less than one year. Get another job, work more than you have in your life.
Others may disagree as it is more efficient to pay down the 26%er. However, if you pay it all of within the year the difference only comes to $260. If you gain momentum, which is important in changing your financial life, that $260 will be meaningless. With focus, intensity, and momentum you can get this mess cleaned up sooner than you think.
However, if you are going to continue to rack up credit card debt at these rates, it does not matter what you do.
(1% of principal) + interest - in that case a directing a payment to the highest interest card will always reduce the next minimum payment by the most.
– GS - Apologise to Monica
Sep 11 '17 at 18:37
The difference in interest is not a huge factor in your decision. It's about $2 per month.
Personally I would go ahead and knock one out since it's one less to worry about. Then I would cancel the account and cut that card up so you are not tempted to use it again.
To address the comments...
Cutting up the card is NOT the ultimate solution. The solution is to stop borrowing money... Get on a strict budget, live on less than what you bring home, and throw everything you can at this high-interest debt.
The destroying of the card is partly symbolic - it's a gesture to indicate that you're not going to use credit cards at all, or at least until they can be used responsibly, not paying a DIME of interest. It's analogous to a recovering alcoholic pouring out bottles of booze. Sure you can easily get more, but it's a commitment to changing your attitude and behavior.
Yes leaving the card open will reduce utilization and improve (or not hurt) credit score - but if the goal is to stop borrowing money and pay off the other card, then once that is achieved, your credit score will be significantly improved, and the cancelling of the first card will not matter. The card (really both cards) should never, ever be used again.
With all due respect to The David, the $1000 is best put against 20%+ debt, no sitting in checking as part of some emergency fund.
I'd agree with the decision to pay off the lower rate card. Why? Because we can do the math, and can see the cost in doing so. Low enough that other factors come in, namely, a freed up card. That card can function as the emergency one in the short term. Long term, once these high rate cards are paid off, you'll build your proper emergency fund, but the cost is too high right now.
The $4000 is a nice start, but the most important thing is to get your budget under control. Only you can decide how much you can cut back, and go after this debt as if it were life or death.
I see some merit in the other answers, which are all based on the snowball method. However, I would like to present an alternative approach which would be the optimal way in case you have perfect self-control. (Given your amount of debt, most likely you currently do not have perfect self-control, but we will come to that.)
The first step is to think about what the minimum amount of emergency funds are that you need and to compare this number with your credit card limit. If your limits are such that your credit cards can still cover potential emergency expenses, use all of the 4000$ to repay the debt on the loan with the higher interest rate.
Some answer wrote that
Others may disagree as it is more efficient to pay down the 26%er. However, if you pay it all of within the year the difference only comes to $260.
This is bad advice because you will probably not pay back the loan within one year. Where would you miraculously obtain 20 000$ for that? Thus, paying back the higher interest loan will save you more money than just 260$.
Next, follow @Chris 's advice and refinance your debt under a lower rate. This is much more impactful than choosing the right loan to repay. Make sure to consult with different banks to get the best rate. Reducing your interest rate has utmost priority!
From your accumulated debt we can probably infer that you do not have perfect self-control and will be able to minimize your spending/maximize your debt repayments. Thus, you need to incentivize yourself to follow such behavior. A powerful way to do this is to have a family member or very close friend monitor your purchase and saving behavior. If you cannot control yourself, someone else must. It should rather be a a person you trust than the banks you owe money.
If your credit is good, you should immediately attempt to refinance your high rate credit cards by transferring the balance to credit cards with lower interest rates.You might want to check at your local credit union, credit unions can offer great rates. Use the $4000 to pay off whatever is left on the high rate cards.
If your credit is bad, I suggest you call your credit card company and try to negotiate with them. If they consider you a risk they might settle your account for fraction of what you own if you can send payment immediately. Don't tell them you have money, just tell them your are trying to get your finances under control and see what they can offer you. This will damage your credit score but will get you out of depth much sooner and save you money in the long term. Also keep in mind that if they do settle, they'll close your account. That way, you leverage the $4000 and use it as a tool to get concessions from the bank.
When paying off multiple debts there is a protocol that many support. Payoff your debts according to the snowball method.
The snowball method proposes that you make minimum payments on all debts except the smallest one. Payoff the smallest debt as quickly as possible. As smaller debts are paid off, that makes one less minimum payment you need to make, leaving you with more money to put against the next smallest debt.
So in your case, pay off the smaller debt completely, then follow up on the larger one by making regular payments at least equal to the sum of your two current minimum payments. You'll see immediate progress in tackling your debt and have one less minimum to worry about, which can serve as a little safety of it's own if you have a bad month.
As to saving the thousand dollars, that is pragmatic and prudent. It's not financially useful (you won't make any money in a savings account), but having cash on hand for emergencies and various other reasons is an important security for modern living.
As suggested in another answer, you can forgo saving this thousand and put it against debt now, because you will have a freed up credit card. Credit can certainly give you that same security. This is an alternative option, but not all emergencies will take a credit card. You typically can't make rent with your credit card, for example.
Good luck paying your debts and I hope you can soon enjoy the freedom of a debt free life.
Patti - I realize, of course, that you pose an either/or question. It seems the question closes the door on other potential solutions.
I'm going to suggest a slightly different approach. Most answers seem to suggest paying off the lower rate card to clear it. Some answers / comments also talk about emergency funds.
One risk of paying off a card is that the card issuer may choose to reduce your credit limit if they see you as high risk, to prevent you re-spending the money. If you don't trust yourself with the card then this could be a good thing (and remember you're always free to ask for a limit decrease).
But if you want access to emergency funds, then I would suggest paying half onto each card. That way if one card cuts you off, you have a chance of still having access to the other in an emergency.
This is the kind of scenario addressed by Reddit's /r/personalfinance Prime Directive, or "I have $X, what should I do with it?" It follows a fairly linear flowchart for personal spending beginning with a budget and essential costs. The gist of the flowchart is to cover your most immediate costs and risks first, while also maximizing your benefits.
It sounds like you would fall somewhere around steps 1 and 3. (Step 2 won't apply since this is not pretax income.) If you don't already have at least $1000 reserved in an emergency fund, that's a great place to start. After that, you'll want to use the rest to pay down your debt. Your credit card debt is very high interest and should be treated as a financial emergency. Besides the balance of your gift, you may want to throw whatever other funds you have saved beyond one month's expenses at this problem.
As far as which card, since you have multiple debts you're faced with the classic choice of which payoff method to use: snowball (lowest balance first) or avalanche (highest interest rate first). Avalanche is more financially optimal but less immediately gratifying. Personally, since your 26% APR debt is so large and so high interest, I would recommend focusing every available penny on that card until it is paid off, and then never use it again. Again, per the flowchart, that means using everything left over after steps 0-2 are fulfilled.
If we're including psychological considerations, then the question becomes much more complicated: will having a higher available credit increase the temptation to spend? Will eliminating 100% of a small debt provide more positive reinforcement than paying off 15% of a larger debt? Etc.
If we're looking at the pure financial impact, the question is simpler. The only advantage I see to prioritizing the lower interest card is the float: when you buy something on a credit card, interest is often calculated for that purchase starting at the beginning of the next billing cycle, rather than immediately from the purchase date. I'm not clear on what policies credit card companies have on giving float for credit cards with a carried balance, so you should look into what your card's policy is.
Other than than, paying off the higher interest rate card is better than paying off the lower interest rate. On top of that, you should look into whether you qualify for any of the following options (presented from best to worst):
I like the answers others gave, if it's some substantial debt you definitely could go the bankruptcy route but it damages your future, also it's morally unethical to borrow all that money and not intend to pay.
Second, if you can pay off the entire balance and clear out the 23% interest than I'd do that first. One less bill to concern yourself with.
Now let's say you've been making $100 payments monthly on each card (my assumption for this examples sale) now instead of paying $100 to the remaining cards balance each month and saving the other $100, pay $200 against the remaining credit cards balance. By not taking home any money this way you are tackling the liability that is costing you money every month.
Unless you have a great investment opportunity on that remaining $1000 or haven't created much of an emergency fund yet, I'd consider putting more of that money towards the debt.
Gaining 0.01% on savings interest still means you're eating 25.99% in debt monthly.
If you're able to I'd venture out to open a zero interest card and do a balance transfer over to that new card, there will be a minimal transfer fee but you may get some cash back out of it and also that zero interest for a year would help hold off more interest accruing while you're tackling the balance.
if it's some substantial debt you definitely could go the bankruptcy route but it damages your future, also it's morally unethical to borrow all that money and not intend to pay. seems like an assumption this money was borrowed without the intent to pay.
– quid
Sep 14 '17 at 00:04