Why You Should Ignore Your Instincts When Paying Your Bills

Paying BillsImagine you're sitting on a park bench one breezy afternoon, minding your own business, when out of nowhere a $100 bill lands in your lap, like a leaf falling off a tree. There's no way to find out who lost the money, so this little treasure is now yours. The only caveat is that you have to use all $100 to pay down some of your debt.

Now imagine you have two credit-card accounts. One has a $100 outstanding balance and a 10% interest rate. The other charges a 15% interest rate on your $1,000 balance. How much do you repay on each account?

This isn't a trick question. If your goal is to get the most bang for your buck, there is a right answer: pay $100 off of the $1,000 balance, as opposed to paying off the smaller, $100 account. Why? Because the higher the interest rate, the more it costs you to carry that debt. This is why financial advisers always suggest paying off our more expensive debt first. Over time, this practice saves us more money.

Why Many Get It Wrong

And yet people often get it wrong, even people who consider themselves financially savvy. At least, that's the conclusion from a recent study in which 171 viewers of "Squawk on the Street," a business news program on CNBC, logged onto the channel's website to answer financial questions like the one above. Roughly one-third of the participants missed the mark, opting to pay off the smaller account, despite its lower interest rate.

"Likely, people feel better [when they close an account]," explains Cynthia Cryder, an assistant professor of marketing at Washington University in St. Louis and one of the study's authors. In other words, watching a $1,000 balance drop to $900 isn't nearly as satisfying as closing a $100 account.

"People like to go for the low-hanging fruit," Cryder says. She's right. When I look at my to-do list, I'm always willing to take out the trash before filing my taxes because running my garbage to the curb gives me a quick and delightful sense of accomplishment, while sorting out my income is a huge hassle.

Turning into the Skid

Choosing to leave open a lower-cost account in order to merely make a dent in the higher-cost one may feel counterintuitive, like turning into the skid when you hit a patch of ice in your car. But it's still the correct way to proceed, and the proof is in the numbers. If you're charged 15% compounding interest per year on $1,000, your balance will be $1,749 after four years. Running those same numbers but with a 10% compounding rate, the balance will be $1,464, saving you almost $300 over the four years.

According to the U.S. Federal Reserve, the country's total outstanding credit card debt is $2.41 trillion and rising. And because consumers who use credit hold an average of four cards, the way we manage our debt payments matters.

However, it can be hard to act against your instincts, which is why Cryder is quick to emphasize the fundamental point that paying off debt is a good thing. "You always want to focus on your debts with the highest interest rates. However, if you're having trouble motivating yourself, it's better to pay down some debt than none. So if you really need to feel great about paying down some debt, go for that small account rather than not paying down any debt at all."

Loren Berlin is a columnist at DailyFinance.com. She can be reached at loren.berlin@teamaol.com. You can follow her on Twitter @LorenBerlin, and become a fan on Facebook.

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steele8682

Does anyone find it strange, or at the very least a conflict of interest, that the National Foundation for Credit Counseling is funded mostly by fair share donations from sub-prime credit card companies?? These donations are tax deductible, and are based more on the amount of money the NFCC returns to these creditors through 501c3 non profits, like Money Management International, with debt consolidation programs, rather than financial literacy merit.

August 17 2011 at 10:32 AM Report abuse rate up rate down Reply
John Walton

The best decision as to which card to pay requires more information than was included in the simplistic example. Was the card with the $100 balance still within the new purchase grace period? If so, no interest would be charged on that account if you paid the $100 soon enough. If the $100 from heaven was the only money available, you had better try to pay both cards the minimum due, or else the late fees on either will be more than the interest saved on the other. All things equal, if you only have two cards and you can keep one of them clean, paying it off in full each month, and paying the other one off as quickly as possible will get you out of debt faster than paying interest on both of them. If you can't handle the dicipline to accompl\ish this, you might as well take the $100 and go an have a real good time while you can.

August 04 2011 at 5:39 PM Report abuse rate up rate down Reply
patmassion

Several years ago Mr. Ramsey said that having a high FICO score was only the result af having had high debt that you paid off according to terms. He went on to say that a high FICO score didn't matter. BULL!! I e-mailed him and told him that we had received several offers from credit card companies for CASH ADVANCES with 0% interest for one year and NO transaction fees!! We took advantage of several offers totaling over $65,000.00 - and put the money into FDIC insured money market accounts paying an average of 6%. After a year, we withdrew the money and off the cash advances IN FULL! We made 6% on THEIR $65K. THEN our insurance company began taking credit into account as part of their underwriting criteria and, LO AND BEHOLD, our homeowners insurance went down by over $300.00 PER YEAR. ( I never heard back fro Mr. Ramsey - surprise, surprise!!) I put everything I can on two cards - one that gives me cash back (3%) on gas and restaurants, the other points tat we use for travel with about a 2% return. BUT I always pay off my balances in FULL each month. Money is a tool, so is credit. Use them wisely and you will benefit, using them stupidly is, well, STUPID!!

August 04 2011 at 3:14 PM Report abuse rate up rate down Reply
patmassion

Dave Ramsey has good advice especially if you HAVE BAD SPENDING HABITS!! BUT if you are smart you wouldn' t get into this mess in the first place. About 3 years ago Mr. Ramsey said that having a high FICO score ONLY means that you have had a lot of debt and paid it off according to the terms of the financing. WRONG!!!! I e-mailed him and pointed out that, several years ago, we were getting credit card offers of 0%, 0 transaction fees on CASH ADVANCES!! Most of these offers were for one year so I took their money and put it into 5 to 6% money market accounts - and when the offers were about to end, I withdrew the necessary funds and paid the cards off IN FULL!!
Then, several years ago, my insurance company began using credit scores as part of their underwriting criteria and,

August 04 2011 at 3:03 PM Report abuse rate up rate down Reply
compuboy

Just try to pay the credit off asap. Then use cash only in the future.

August 04 2011 at 2:03 PM Report abuse rate up rate down Reply
Lightning F2A

If you're trying to decide which credit card to pay, and you are not paying them off in full each month, then you are basically choosing between a punch in the gut or a kick to the balls. Either way it's going to hurt.

August 04 2011 at 1:46 PM Report abuse rate up rate down Reply
1 reply to Lightning F2A's comment
biglou001

FInally a post that actually makes sense...bravo!

August 04 2011 at 1:50 PM Report abuse rate up rate down Reply
RFDF

Just a question about Mortgages, can you make payments every 2 weeks without doing any kind of refinancing or extra charges from the bank?

August 04 2011 at 1:16 PM Report abuse rate up rate down Reply
2 replies to RFDF's comment
biglou001

Depends on the bank so I would call and ask. Some allow it, but some will not process the payment until the end of the month resulting in 0 savings on the back end.

August 04 2011 at 1:24 PM Report abuse rate up rate down Reply
mne543

you can... there's nothing that says you can't-- but the payment will be applied towards your next bill, and will not go directly to the principle balance. Some mortgage companies offer no-charge switch to Bi-Weekly payments (which equals one full extra payment per year), and that would be the best option. If not -it's better to send extra with your normal monthly payment; the extra money will pay down the principle, thus decreasing the amount of interest you pay in the long term, and, it will pay off your loan a lot quicker.

August 04 2011 at 1:47 PM Report abuse rate up rate down Reply
jim43miller

You should not necessarily pay first the card with the higher rate. You should pay the one that is costing you more in interest. (Although in the example given it's the same, it won't always be.) You can have a low rate card with a high balance costing more money per month than a high rate card with a low balance. Your goal is to pay the least interest, so pay down the one that's costing the most. You have to pay attention, because which costs more will change as you juggle the payments around to the various cards.

August 04 2011 at 1:15 PM Report abuse rate up rate down Reply
barryaclarke

Maybe I am missing something. But if you paid a $100 of a $1,000 debt at 15%, you would be saving $15 in interest. If you pay $100 of a $10,000 debt at 10% interest, you would save $10 in interest. The net result would always be that you save the most by paying off the higher interest rate as shown in the above example.

August 04 2011 at 1:14 PM Report abuse rate up rate down Reply
Orlenda

ok what would we do if we had a card with a lower balance but highter rate, and another with a higher balance but lower rate?

for example:
balance-$100, rate-25%
balance-$500, rate -10%

August 04 2011 at 1:04 PM Report abuse rate up rate down Reply
1 reply to Orlenda's comment
biglou001

Same principle.

August 04 2011 at 1:17 PM Report abuse rate up rate down Reply