With multiple credit card debts, is it better to pay the largest debt or the smallest debt first?
If you were to dive into my inbox, you might assume you'd find lots of questions on laundry, copycat recipes, or what the best inexpensive fill-in-the-blank is. I do get lots of those. But it’s questions about credit cards and consumer debt that come out the winner in that contest.
You, like I, may find that curious because I am not a financial planner or investment adviser. I can boast no licenses or certifications in those fields. I have life experience, and I have that in spades.
I’ve been horribly in debt, having owned 35 credit cards (yes, all the same time!) many years ago. I’ve foolishly leased a bevy of new cars. I’ve hit rock bottom, struggled madly to escape the sea of financial ruin, and am now onto the dry ground of living 100 percent debt-free!
I have learned a lot on the journey. What follows are the questions asked most often and my answers, representing my own opinions. I invite you to take them for what they’re worth.
Q: Should I take a home equity loan to pay off my credit cards?
A: No. The best way to understand this is to consider the worst-case scenario: What are the consequences if you cannot keep up with your payments?
If you default on a credit card account, the bank will charge you fees and penalties and trash your credit report. But they cannot take your home. But if you transfer that unsecured debt to your home using a home equity loan and then get into financial trouble, you could find yourself on the street with your recliner.
Defaulting on a home equity loan results in foreclosure. But it’s more than that. Your home’s equity is an appreciating asset. Left alone and allowed to grow over time, you will eventually achieve 100 percent equity, meaning you own a house free and clear. You'll never reach that goal if you keep looking at your home’s equity as an ATM or secret savings account.
Q: Should I really put money into savings even though I have a lot of credit card debt?
A: Absolutely. You need an emergency fund—a stash that will be there when you find yourself in a financial pickle. Here’s why: If you do not have an emergency stash to cover stuff that happens (trust me, stuff always happens), you will have no choice but to run to a credit card for a bailout. You'll never get off the credit card debt treadmill if you don’t stop adding new purchases—even if it’s an emergency. You need to save something from every paycheck (10 percent sounds about right to me) so you can eventually part company with credit card debt altogether.
Q: Which credit card bill should I pay off first, the one with the smallest balance or the one with the highest interest rate?
A: You should target the smallest debt first. Here’s why: We are emotional creatures. We need gratification sooner rather than later. If it takes you five years to pay off your debt with the highest interest because it just happens to be your largest debt, too, you will get discouraged. But if you target the smallest one and manage to pay it off in a few months, locking eyeballs with that $0 balance will give you a huge emotional payoff and precisely what you need to keep going by tackling the next most enormous debt, and on and on until every credit card balance is at $0.
Q: Should I use my tax refund to pay down credit card debt or stash it into an emergency fund?
A: That depends on your current savings situation. If you have at least enough cash put away in a savings account that is sufficient to pay all of your bills for three months without a paycheck, then I think using your refund to pay down your debt is a great idea. But if you don’t have an emergency fund, saving your refund might be a terrific way to give your emergency fund a jumpstart.
Q: Should I transfer my debt to a zero percent credit card?
A: It’s tricky, and it all depends on your situation, the terms of this new zero percent card, and your determination to use it to your best advantage. Make sure you read that fine print several times and that you fully understand it. (Good luck. One study says some terms and conditions are written at a 27th-grade level.) Is there a transfer fee?
If you transfer a $5,000 balance subject to a four percent transfer fee, that would be $200 right up front. Ouch! How long does the zero percent teaser rate last? What is the default rate, and could you handle that big interest rate if something unforeseen happens and you fall behind? If you are determined to pay the balance in full within the next six months, and there is no transfer fee, you may come out ahead.
The bottom line is that it’s always a gamble with credit card accounts. You have to work hard to beat the banks at their own game to make you the winner!
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