Question

Consider a simplified situation where you have two credit cards. Credit card 1 has a balance of $1,132 and has a 5% interest rate. Credit card 2 has a balance of $5,273 and a 14% interest rate. What is the best strategy to reduce your debt? (Assume consolidation, balance transfers, and other debt management strategies are not options)

Group of answer choices

Figure out the maximum amount of money you can afford to pay and pay it equally on both cards.

Pay the minimum on both cards.

Pay the minimum on card 1 and as much as possible on cart 2. When card 2 is paid off pay as much as possible on card 1.

Pay the minimum on card 2 and as much as possible on card 1. When card 1 is paid off pay as much as possible on card 2

Answer 1

This is a question about what's often called the "avalanche method" versus the "snowball method" of paying off debt.

The avalanche method involves paying off the debt with the highest interest rate first, which minimizes the total interest you'll pay. The snowball method involves paying off the smallest debt first, which can provide a psychological boost, but may lead to paying more interest overall.

Given the balances and interest rates on these credit cards, you would save the most money by using the avalanche method. This is because Credit Card 2 has a much higher interest rate, and a balance that's also higher than Credit Card 1.

The more interest a balance accrues, the more you ultimately have to pay back. So, it's best to eliminate the highest-interest debt first if you're solely aiming to pay as little as possible in the long run.

Therefore, the best strategy in this case, to reduce your debt in the most cost-effective manner, is to:

"Pay the minimum on card 1 and as much as possible on card 2. When card 2 is paid off, pay as much as possible on card 1."

Note that this advice is focused on minimizing your total payments. There can be psychological benefits to paying off smaller debts first (the "snowball method") because it can feel like you're making more progress. But if you're looking to pay the least amount of money overall, focusing on the debt with the highest interest rate is the way to go.