NEW YORK (MainStreet) — Most credit card users know it is folly to rack up big balances and pay interest and penalties for years. But as the pricy holiday season winds down, let’s be realistic: Sometimes you have no choice but to carry a balance for a while.
This is a good time, then, to look at the fine points of whittling a debt over time. Using debt calculators can give a complete view of the pros and cons of various options such as consolidating debt to pay a lower interest rate, directing bigger payments to the most expensive card or simply paying a bit more than each card requires.
There are a couple of underlying principles. First, the top priority is to avoid missing payments. A missed payment will trigger a costly penalty, could get you a higher rate on your remaining debt and could damage your credit rating.
Second, it makes sense to direct extra payments to the debts charging the highest rates. Paying $100 on a debt charging 15% is like earning 15% in a savings account, since it will save you $15 a year in interest charges. The same $100 would “earn” just 8% on a debt charging only 8%.
Third, maximizing your payments has a snowballing effect, similar to the compounding you get in an investment. As the debt gets smaller, a bigger portion of each subsequent payment goes to paying down debt rather than interest. If you paid an extra $100 a month, each month’s payment would take a bigger bite out of your outstanding balance.
Let’s look at what the four debt calculators can tell us, starting with the BankingMyWay Credit Card Minimum Payment Calculator. With the default figures of $5,000 in debt charging 18.9% and a minimum payment of 4% of the balance, it would take nearly 13 years to pay off the debt, with payments totaling more than $8,000. Cut the interest rate to 10% — something you could do by transferring the debt to a cheaper card — and the payoff time drops to about 10 years and total payments to about $6,300, a significant savings.