Where Your Credit Card Payment Really Goes

So my Dad and I were discussing credit card stuff (he's in the business). He made a very important point which I haven't heard discussed much. It's something that you don't hear often with all these great offers of balance transfers or when people advise you to get your rates lowered:

The credit card company will pay off your lowest interest balance first with the money you send in. This is guaranteed to cost you money. The amount depends on your balance and percentages.

An example. Suppose Mr. Micah and I had $5000 of debt at 30% APR. Now, we called the company and they agreed to lower our APR to 13%. But this APR would only count towards new purchases (they don't always say this part, so be sure to check with them. it's hidden in the fine print). Now we have to spend $1500, perhaps for car repairs.

But we've turned a new corner and so we're planning to pay off the debt right away. We decide to start sending in monthly payments of $250 (because that's all we're able), which is above the minimum..

But here's the trick. The $250 will be applied to our $1500 purchase, not our $5000 of old debt. So the $5000 will continue to accumulate interest at the old rate. Credit card companies have this policy because it helps them make money. They could do it in our favor and still make interest, but they'd rather make us pay more.

If we pay off $250 every month, we'll eventually pay off the whole thing. But we will have paid more money total (because of the higher APR) than if we'd gotten them to apply our payments to the balance with the higher APR. In this case, $369 more would go to the CC company. If you're a millionaire, maybe you can afford this. But why let over $350 get away from you?

So find out how your CC company will let you pay off the higher-interest balance first. Maybe it's as simple as writing on the check line, "apply to higher-interest debt." But call them. Don't assume. A simple call to their service people should help you find out the exact protocols of your company.

Even if the service people annoy you, do it. Avoiding this call will cost you in the long run (especially if you always carry a balance, since it's guaranteed to be at the higher rate!). Make the call today.

(note, here's a link to the spreadsheet I used for my calculations. 30% APY means 2.5% per month. 13% means 1.08% per month. We assume that you begin with sending in $250 right away. Good job! Please let me know if you have any methodology questions.)