As we welcome in the new year, with resolutions to extinguish credit card debt, consumers need to look at how they pay, not just what they pay. This study from the UK suggests that many strategies are awry, and with rising interest rates, cardholders should take a look at pushing payments towards higher rates, not just the largest balances.
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Say you have two or more cards that you carry a balance on and you have a set amount of cash each month you can use to pay down all your cards. If you want to ensure you pay the smallest amount of interest, thus eliminating your debt the fastest, you have to do just two things: First, pay the minimum amount on each card. Second, dedicate all of your remaining money to the card with the highest interest rate.
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Easy, right? As it turns out, the overwhelming majority of people are not paying their cards off that way.
The takeaway is to focus on making higher payments to high rate cards, not necessarily higher balances.
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In a new study out of England, researchers analyzed repayment behavior among 1.4 million individual credit card holders, focusing on people with multiple credit cards with revolving balances (those people who don’t pay off their balance every month).
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This sets up a situation in which individuals have to choose how to allocate their debt payments: Do they split payments between cards based on interest rates, or debt balance, or by some other factor?
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While debtors should have been allocating close to 100 percent of their excess payments (over the minimum amount) to the highest APR card, instead they were devoting “only 51.5% of their excess payments to the high APR card, behavior that is virtually indistinguishable from the completely nonresponsive baseline.” It did not look like people were considering interest rates at all, in other words. Only 10 percent of the individuals in the study were devoting all their excess payment to the high-interest card.
As households look at their monthly budgets, the takeaway should be to allocate payments towards the highest rates, not the highest balances, which is particularly important as we begin to see additional rises in interest rates.
Overview by Brian Riley, Director, Credit Advisory Service at Mercator Advisory Group
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