If you’re at the beginning of your debt-payoff journey, the chances are that you have more than one debt. You may be wondering how you should prioritize your monthly payments on those credit accounts. There are two main schools of thought when it comes to creating an effective plan However, there is an additional strategy that may merit your attention.
Highest interest rate versus lowest balance
There tend to be two approaches when it comes to paying off debt. In order to enact either plan, you first determine what all your minimum payments are. Then you check your budget to see how much extra cash you can allocate towards debt in addition to making those minimum payments.
The first strategy is to allocate your extra payment towards the debt with the highest interest rate. According to Beverly Harzog, credit card expert and author of “The Debt Escape Plan,” this is sometimes called the “avalanche method.” You may pay significantly less in interest by adopting this strategy.
The common second strategy is to take your extra funds and apply them toward the debt with the lowest balance. Eliminating a debt completely soon after committing to a payoff plan may keep you motivated. Harzog says this is popularly referred to as the “debt snowball method.”
In order to enact either plan, you first determine what all your minimum payments are and then check your budget to see how much extra cash you can allocate towards debt in addition to making those minimum payments.
What about your credit score?
“A credit-utilization ratio looks at how much you owe against your available line of credit,” says Gail Cunningham of the National Foundation for Credit Counseling (NFCC). “It is important since it is the second highest weighted element of the FICO scoring model.”
Ideally, you don’t want to carry a balance at all. If you have no choice but to carry a balance, Cunningham says that “the NFCC recommends not utilizing more than 30 percent of your credit line.” But here’s where it gets tricky.
Credit bureaus look at the utilization on a single card (line item utilization) as well as your aggregate utilization percentage, which includes the debt-to-limit ratio of all of your cards combined. For example, say that you have two cards, each with a $10,000 limit. Even if you have a zero balance on one card, if the other has a balance of $9,800, then your credit score may be negatively impacted.
“Because the FICO score takes into account your ratio across all of your cards as well as individual card accounts, it’s good practice to spread out your charges and not run up a high balance on one card,” Harzog says.
A third option: Focusing on credit utilization?
If you’re near or even over the limit on multiple credit cards, then it may be tempting to get another card and keep it at a zero balance in an attempt to improve your aggregate utilization. However, you probably won’t qualify for the best credit cards. Additionally, your line item utilization on the original accounts will remain high, and this move doesn’t get you out of credit card debt any quicker.
There’s also the temptation to spend with that new credit card, which can get you into even more trouble.
“It’s more important to choose a debt repayment method that works for you than it is to worry about how quickly you can raise your score,” Harzog says.
If increasing your credit rating is something you find motivating, then you may want to prioritize your extra payments in a way that focuses on both line item utilization and aggregate utilization.
“If any account is over the limit, bring down that debt immediately, as it is costing you the most due to overlimit fees being added on each month,” Cunningham suggests. “Next, tackle the account that has a balance closest to the maximum line of credit and begin bringing it down.”
As your debt goes down on that card with the highest credit-utilization ratio, your credit score will start to rebound.