Pay Off High-Interest Credit Cards First

Added February 28, 2001 by Ilyce R. Glink

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Summary: You should always pay off your high-interest, non-deductible debts first. When you prepay a debt, you're effectively earning the interest rate the debt carries on each dollar. Once your debts are paid off, you start savings the cash you would have paid each month to service the debt. Consider using your tax refund to pay credit card debt, or take out a home equity loan with a lower interest rate than your credit cards.

Q: I'm carrying about $12,000 on five different credit cards. The average interest rate is 17 percent. I want to pay them all off.

Here are my options. I have a huge tax return check coming my way in about 2 weeks. Should I use the tax return money to pay off my debts, or should I invest this money? Do you think I should try to get a home equity line of credit at a low rate and pay off my credit cards?

A: You should always pay off your high-interest, non-deductible debts first. When you prepay a debt, you're effectively earning the interest rate the debt carries on each dollar. So if your credit card debt is being charged 17 percent, prepaying that debt actually earns you 17 percent on your money. That's way better than the stock market or any other kind of investment I can think of.

Once your debts are paid off, you can use the cash you would have paid each month to service the debt to start building a retirement fund. If you qualify, I suggest you open a Roth IRA and start investing those after-tax dollars in an index mutual fund.

If you weren't getting a big tax refund, I'd suggest using a home equity line of credit or home equity loan to pay off your credit card debt. It doesn't make sense to pay 17 percent on non-deductible credit card debt when you could be paying 6 percent on deductible home equity debt.

Finally, try to adjust your withholdings, so that you end up with only a small refund or no refund for this year. There's no sense in giving Uncle Sam an interest-free loan.

Published: Feb 28, 2001

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