Since her graduation, Penny has been accumulating credit card debt, which she struggles to repay with sporadic income as an aspiring actress and part-time waitress. As of today, she has a $1,889 outstanding debt on Card Alpha, a $971 outstanding balance on Card Beta, and $540 on Card Omega.
Card Alpha has an interest rate of 15%, while Card Beta has an interest rate of 28%. Card Omega is a new card with a an introductory one-time offer of 0% interest for ten more months. All the cards have minimum payments of $50.
She has $1,050 on hand this month budgeted for debt repayments, which is clearly insufficient to pay off the debts in full. Given the above considerations, how should she allocate her limited funds between the three credit cards?
|Card||Outstanding debt ($)||Interest rate||Minimum payment ($)|
|Omega||540||0% (promotion for 10 more months)||50|
You know that Penny should set aside part of the budget to meet the minimum payments on each card; this is non-contentious.
After that is taken care of, she’d be left with $900, which we will term X for the sake of brevity. Being a hip millennial wannabe, Penny posted her dilemma on her social network and got some advice from well-meaning friends.
Bernadette’s suggestion may sound condescending, but surprisingly, it is a valid course of action. The potential savings from proper allocation may not be worth the time and effort needed to optimise the allocation. Sadly, we know that being too lazy to optimise is sometimes being Penny wise, pound foolish (pun intended).
It doesn’t take a rocket scientist to see that Howard’s suggestion is the optimal solution. It is simply the most cost-efficient way to pay down debt on multiple credit cards. It may be the correct solution mathematically, but some might not be comfortable with just covering the minimum for the other two cards.
As it turns out, it is Sheldon’s prediction which is substantiated by the latest research findings that describe actual human tendencies in debt repayments. In the case of having debt on 3 cards, the optimal solution (red line in radar chart below) should be to pay off the card with the highest interest rate.
Surprisingly, what most people actually do (blue) is to distribute X in direct proportion to the balance outstanding on each card.
Rajesh’s suggestion is very popular among experts who peddle debt advice. They will allude to understanding the psychology and psyche of the debtor to generate quick wins, instead of looking at the bottom-line.
In effect, paying down the card with the lowest balance may be more expensive in the long run. Advocates may call this strategy “quick wins” while critics like to call it “debt snowballing”.
While the mathematically optimal strategy is clear and we’d highly recommend that Penny clear her debt on Card Beta first, the other strategies also have their places. As dieting coaches like to point out: better a suboptimal strategy you can understand and adhere to until the end, than an optimal strategy that you cannot stick to and fail halfway.
In the end, Penny disregarded all the advice above and followed her heart. She harnessed her acting skills and managed to convince her husband Leonard to pay off all outstanding balances on her credit cards. Dare I say, she may be the smartest one after all.