If you find yourself accruing debt – especially over multiple credit cards or other sources – it can be tough to prioritize and organize a good strategy for repayment. One of the most commonly cited strategies for dealing with multiple sources of debt is to make the minimum payment on each source, and devote the rest of your available budget for repayment to the source with the highest interest rate. This saves you from being penalized for lateness, and allows you to review and re-allocate your budget as needed.
Sounds simple, right?
Unfortunately, according to a study based in the U.K. and conducted by the National Bureau of Economics Research (NBER), many people struggling with debt are not using the most effective strategy for their situation. This could be the one mentioned above, or another one determined by an advisor or expert.
The amount of money lost to interest goes up remarkably quickly as the number of debt sources you may take on increases. The study found that a debtor with two credit cards owing balances lost an average of the equivalent of $83 per year. Increase the number of debt sources to five, and that number increases to roughly $350 per year.
The NBER study asked participants to choose the most effective/efficient option among the following strategies for debt reduction:
The 1/N rule: Split payments equally across cards. With two cards, and $100 to make payments, $50 goes towards paying down the balance on both.
Balance matching: Make payments based on the relative size of outstanding balances. With $300 to make payments on two cards, one with a balance of $2,000 and another with a balance of $1,000, this means something like $200 goes towards the $2,000 balance card, and $100 to the $1,000 balance card.
Repay the card nearest its credit limit: This prioritizes payments on cards at risk of going over their credit limit and incurring an extra fee.
Repay the card furthest from its credit limit: This gives the user the ability to make a big payment, if needed, the next month.
Repay the card with the highest balance: The balance is the most conspicuous number that borrowers see on their statement, so the largest sums may attract the bulk of repayments.
Repay the card with the lowest balance, with the intention of getting that card to zero (the “snowball method”): Some financial advisors suggest this strategy, arguing that it simplifies a person’s debt portfolio and makes them feel good, thus generating a “snowball” of good behavior.
Which would you choose? Why?
It turns out that the majority of respondents to the study thought that “balance matching” was the most efficient method for getting rid of their debt. At first glance, it makes sense: you’re allocating a bigger or smaller payment relative to the size of each balance. However, balance matching does not take interest rates into account. What if the card or source with the highest balance has the lowest interest rate? It’s almost inevitable that the interest accrued across multiple sources will outweigh the balance reduction.
As Canadian household debt levels continue to rise, it is clear that individuals looking to lower their debt will need to optimize the process of doing so in whatever ways they can. Once you have evaluated your spending, savings, budgeting and other variables, take a look at your repayment strategy – it could make a huge difference in your ability to tackle debt no matter the source.