If you’re juggling multiple balances on a handful of cards, there are any number of wrong ways – and one right way – to divvy up your credit card payments.
New research by the National Bureau of Economic Research suggests that most people revolving balances on multiple cards wind up paying unnecessary interest because of the irrational way they allocate their payments.
Rather than pay down the credit card with the highest interest rate first – which is what most personal finance experts recommend – people often send too much of their money to cards with lower interest rates and too little of their money to cards with the most expensive balances.
As a result, they wind up paying more overall, the analysis of more than a million cardholders in the United Kingdom found.
Snowball, avalanche or something else
These cardholders aren’t necessarily following the famed “snowball method” of debt repayment either.
Some experts, such as personal finance guru Dave Ramsey, counsel cardholders to build momentum by paying off the cards with the lowest balances first and then moving on to cards with higher balances. While they pay more interest overall, the “small wins” help cardholders stay on track paying down their debt to zero.
Research has found that the so-called “snowball method” is surprisingly effective in helping motivate people to tackle large amounts of debt.
But instead of applying either the “snowball method” or the “avalanche method” (pay off the card with highest APR first), cardholders in the NBER study tend to divide up their payments more illogically.
For example, they might split up their payments 50-50 between cards. Or they might allocate bigger payments to the cards with the largest balances.
Researchers call this tactic “balance matching.” Cardholders match their payments to the balances they owe, rather than to the cost to borrow.
Rational and irrational debt payoff strategies
For many cardholders, this “balance matching” strategy might make intuitive sense, even if it isn’t fully rational.
I pay off all my balances in full, but if I had multiple balances on a handful of cards, I would likely pay more to the largest balance just so I could feel as if my balances are more manageable – even if the biggest balance I owe is on my lowest rate card.
The bigger the balance I have on one card, the more I feel overwhelmed by it.
Another reason cardholders may do this: People will often focus more attention on the balances owed on their cards (which may be the first thing they look at when they open their statements) rather than their APRs, the NBER researchers wrote.
Cardholders who focus their attention on a card balance or a minimum amount due – are a gift to credit card companies who are happy to collect more in interest.
Previous research has found that cardholders “anchored” on paying only the minimum balance “pay less of their debt than they otherwise would, leading to higher balances and interest costs, lower credit card scores, increased bankruptcy risks.”
If you really want to knock out your balances with the least amount of financial pain you’d be better off paying as much as you can afford on the card with the highest interest rate before allocating a larger amount to cheaper cards.
You’ll not only save more on interest that way, you also may pay off your debt faster since you won’t be weighed down by unnecessary payments.