For some people, it may sound like common sense to pay off higher payment installment loans first before paying off their low payment credit card debt. However, that is not always the case and in fact, could be the opposite. An installment can be a furniture loan, auto loan, or a personal loan.
The key difference between an installment loan and a credit card is that an installment loan has a definite end to the loan. Knowing when your loan will be paid off also lets you know how much the loan is going to cost you.
That is not the case with a credit card. Credit card companies first choose an arbitrary monthly payment low enough to entice customers to continue paying the card over a longer time frame. Let’s take a look at an example for both installment loans and a credit card carrying a balance.
Let’s start with an installment loan example. Say you took out a $1,000 personal loan at a 36% interest rate for 12 months. Your monthly payment will be $100.46 for 12 months.
Over the 12 months, you will only pay $205.52 in interest. Adding the original $1,000 you took out and the $205.52 in interest together, you would have paid a total of $1,205.52 in payments over 12 months.
As we can see, the personal loan has a higher interest rate but a low term. Now let’s look at a credit card example and compare how much you would spend in total.
CREDIT CARD DEBT
We will keep the balance the same in both examples. Say you spent $1,000 on your credit card. Your credit card has an interest rate of 20% and the monthly payment is $36.00.
Just like the installment loan, the monthly payment has a portion of the payment go to interest and a portion going to principal. Because credit cards do not have a definite end, we need to figure out how long it will take us to pay off the card with a $36 principal and interest payment.
The easiest way to find how long it will take to pay off the card is to use an amortization calculator and solve for the term. Based on the balance, interest rate, and payment given to us by the credit card company, we found that it would take about 38 months to pay off the $1,000 dollar balance.
Multiplying the $36 payment by 38 months, you would have paid a total of $1,368 in payments and $368 in interest ($1,368 – $1,000).
PUTTING IT ALL TOGETHER
Let’s compare both examples. As you have probably already seen, it’s more expensive to pay the low monthly payment credit card than to pay the higher interest personal loan. You might be thinking to yourself how this is possible if the personal loan has a higher interest rate.
Interest rate is only one factor that affects your cost on a loan. Another factor is the term or the lifetime of the loan. Interest rates are defined in years. For instance, the personal loan had a 36% per year interest rate. The credit card had a 20% per year interest rate.
While we only had the personal loan for a year, we carried the credit card balance for more than two years. That’s 20% per year we carried the balance or 40% in total.
As you saw, a 20% low-interest-rate doubled because there was no end to the credit card balance. So next time you are thinking about paying off your installment debt, first think about the credit cards you still have balances on and pay those off first. It will save you money in the end.
If you are looking at paying off credit card debt but don’t have the available cash now, get a personal loan with SonAriz Financial and stop paying too much on credit card debt. Call us or fill out an online application here to get started.