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Three Methods To Reduce Credit Card Debt
How to Allocate Extra Money to Pay Down Your Debt
Reducing your debt will reduce the interest payments you are making. Credit card debt is often some of the highest interest debt you will ever have. The more debt you can eliminate, the more money you will save. And every dollar you save in debt payments is a dollar you can spend or invest.
There are three basic methods to determine how to allocate payments to reduce credit card debt. In most cases they all seem to eliminate debt within a couple of months of each other.
These methods involve paying an amount that is more than the minimum payments of your credit cards. So, let's say that your initial minimum payments for credit cards comes to $480. And, let's say that you are able to make a consistent payment of $580 per month on your credit cards. These three methods allocate extra money ($100) in different ways.
In each case, when one debt is paid off you then allocate all the money you were paying on that debt to the next debt, and so on.
The three methods allocate the money in excess of the minimum payments as follows:
- To the smallest debt. This will quickly eliminate that debt giving you a psychological boost.
- To the debt with the highest interest rate. This helps reduce the total amount of your interest payments.
- To all debts in proportion to the amount owed. This will eliminate all debts at nearly the same time.
Let's see how this works. Suppose you have four credit cards with a total debt of $12,000. The debt is divided between the cards as follows:
| Credit Card | Debt Amount | Interest Rate | Interest Charge |
| Visa - Bank A | $3,500 | 21% | $61.25 |
| MasterCard - Bank B | $2,500 | 19.8% | $41.24 |
| Department Store A | $4,000 | 17.9% | $58.67 |
| Department Store B | $2,000 | 12.9% | $21.50 |
| ==================== | ======== | | ====== |
| TOTALS | $12,000 | | $183.67 |
Minimum Payment: 4% of Debt $480.00
Your first payment will include $183.67 as interest on your four cards.
Note that the minimum payment for credit card debt is typically 4% of your debt. For a debt of $12,000, this comes to $480. This is about $300 more than the interest charges in this example.
Let's say you want to pay off the loans faster. You can add $100 each month to your payment. This means, each month you will pay $580 toward the reduction of your credit card debt.
The more money you add to the minimum payment amount, the quicker you will be able to eliminate your debt. The minimum payment amount is only the amount that will keep your account from being flagged as delinquent.
The three methods vary in how to allocate the $100 in excess of minimum payments.
For the first method, you would allocate the $100 to the smallest debt (Department Store B).
Allocate Excess Money to the Smallest Debt
| Credit Card | Minimum Payment | Actual Payment |
| Visa - Bank A | $140 | $140 |
| MasterCard - Bank B | $100 | $100 |
| Department Store A | $160 | $160 |
| Department Store B | $80 | $180 |
You would continue these payments (totally $580) until Department Store B's debt is paid. They you would allocate the extra $180 to the next smallest debt. And so on until all the debts are paid.
This method pays off Department Store B's debt after 11 months. This should give you a morale boost to lest you know that you are really making progress.
Allocate Excess Money to the Highest Interest Rate Debt
For the second method, you would allocate the $100 to the debt with the highest interest rate. In this case, you choose Visa at Bank A with the 21% interest rate.
| Credit Card | Minimum Payment | Actual Payment |
| Visa - Bank A | $140 | $240 |
| MasterCard - Bank B | $100 | $100 |
| Department Store A | $160 | $160 |
| Department Store B | $80 | $80 |
You continue these payments, again totaling $580, until the Visa Bank A debt is paid off. This debt will be paid off after 17 months. You will then allocate the extra $240 to the MasterCard Bank B payments until that debt is paid off. And so on until all the debts are paid off.
Allocate Excess Money Proportional to the Debt Amount
In the third method, you need to compute the amounts you allocate to each of the four cards. You initially own $12,000. The amount of the excess money you allocate to each card in general is as follows:
Amount for "Card A" = (Total excess) x ("Card A" debt) / (Total debt)
For our four cards, the amounts would be:
Visa Bank A: $100 x ( 3500 / 12000 ) or $29.17
MasterCard Bank B: $100 x ( 2500 / 12000 ) or $20.83
Department Store A: $100 x ( 4000 / 12000 ) or $33.33
Department Store B: $100 x ( 2000 / 12000) or $16.67
The amount you owe will change from month to month since you are paying down your debt. You can calculate each month how to allocate your money or use the above figures for 6 months or a year, then recomputed the values.
| Credit Card | Minimum Payment | Actual Payment |
| Visa - Bank A | $140 | $169.67 |
| MasterCard - Bank B | $100 | $120.83 |
| Department Store A | $160 | $193.33 |
| Department Store B | $80 | $96.67 |
You will always make the minimum payments above, plus allocate the $100 to the various debts until they are all paid off.
So, what are the effects of allocating excess money in these different ways? Are there dramatic differences in how fast the loans are paid off? Do you get to save a lot of money using the "right" method?
Here are the results of using the three methods with the sample debts.
| Method - Excess Payment to: | Months to pay Off Total Debt | Total Amount Paid | Total Interest Charges |
| Smallest Debt | 26 | $14,618 | $2,618 |
| Highest Interest | 25 | $14,471 | $2,471 |
| Proportional to Debt | 26 | $14,551 | $2,551 |
As you can see, the differences are minor. Only $147 in total payments separates the three methods with a total payoff difference of 1 month.
Because the differences are so small, you can choose the method you use based on your own preferences.
If you are interested in a psychological boost by quickly paying off a loan, then pay off the smallest loan first. This will get it out of the way quickly.
If you are interested in paying the absolute least amount of money with the quickest elimination of total debt, use your excess money to pay off the debt with the highest interest rate first.
If you want to practice using a spreadsheet or your calculator you can allocate the excess money proportionally to the debts based on the amount owed.
The important fact to note is that by adding $100 to your payments, you paid off your debt in just over two years.
Without the extra $100, paying just $480 per month, you would have to pay for 34 months to eliminate your debt. You would pay a total of $15,276 with $3,276 in interest. Paying the extra $100 per month saved you about 9 months and around $700 in interest charges.
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