Spot costly debt and clear it fastest
How to tell cheap borrowing from costly debt by its APR, why minimum payments keep you in debt for years, and how to choose the order to repay several debts.
FinanceEveryday moneyAbout 6 min: 4 reading, 2 practiceUpdated
General education, not financial advice.
- Compare debts by APR and say which are costly
- Work out a month's interest and why minimum payments take years
- Choose an order to repay several debts and explain the trade-off
Builds toward: Run your own money. Budget so there's room to save, spot and clear costly debt, compare savings and loan offers, and see what interest and inflation do to your money.
Everyday money: budgets and debt: lesson 2 of 2
- Everyday money
- Make a budget that leaves room to save 6 min
- Spot costly debt and clear it fastest 6 min
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Pairs with any consumer guide to credit and debt, such as your national money-advice service or financial regulator; research on debt repayment such as Gal and McShane's 2012 study of "small victories"
What it is
The APR (annual percentage rate) is the yearly cost of borrowing, including most fees, as a percentage. It is the number to compare, whatever the advert's headline says.
Borrowing ranges from cheap to very costly. Typical ranges vary by country and year, but the order is fairly stable:
- Cheaper: mortgages and many car loans, often in single figures.
- Costly: credit cards, store cards and arranged overdrafts, often around 20% to 40% a year.
- Very costly: payday and other short-term loans. In the UK the regulator caps their interest and fees at 0.8% a day, and in total at no more than the amount borrowed (so you never repay more than double). That still works out at hundreds of percent a year.
Costly debt is any debt whose rate is well above what your savings earn. Paying it off is like earning that rate, guaranteed.
On a card, interest is charged each month. Roughly, the monthly rate is the APR ÷ 12. A balance of 2,400 at 24.9% costs about 2,400 × 24.9% ÷ 12 ≈ 50 in the first month. (This lesson uses APR ÷ 12 throughout, as US cards do. A UK APR already includes monthly compounding, so the true monthly figure there is a little lower, about 45 in this case; the lessons are the same.)
Quick check
Tap an answer to check it.
A card charges 24.9% APR and your savings earn 4%. You have 1,000 in savings beyond your emergency fund and owe 1,000 on the card. What does paying off the card do?
- The card costs far more than the savings earn
Show answer
Saves about 249 a year in interest, against about 40 the savings would earn. Clearing costly debt is a guaranteed return at its interest rate.
Why it matters
The minimum-payment trap. Card minimum payments are set low, often a small percentage of the balance, so most of each payment goes on interest.
Take the 2,400 card at 24.9%, with a minimum of 3% of the balance (after that month's interest is added) or 25, whichever is more:
- Paying only the minimum: about 164 months (almost 14 years) to clear it, and about 3,890 in interest, more than the original debt.
- Paying a fixed 100 a month: about 34 months, and about 960 in interest.
- Paying a fixed 150 a month: about 20 months, and about 550 in interest.
The difference comes from one habit: a fixed payment that doesn't shrink as the balance does.
Several debts: which first? Always pay every minimum, then put all your spare money on one debt:
- Avalanche: the highest APR first. This saves the most interest.
- Snowball: the smallest balance first. A study of thousands of people in a debt-settlement programme, by Gal and McShane (2012), found that the share of accounts people had closed predicted whether they cleared all their debt better than the amount of debt they had paid off, so the quick wins may help people keep going.
The avalanche is cheaper on paper; the snowball may be easier to stick to. The best method is the one you keep to.
Worked example
Two cards and 150 a month to spend on them:
| Card | Balance | APR | Min. |
|---|---|---|---|
| A | 1,500 | 29.9% | 25 |
| B | 600 | 19.9% | 25 |
Pay 25 on each, and the other 100 on one card, then roll the payment on to the other once the first is clear. Modelled month by month:
- Avalanche (card A first, highest rate): clear in about 17 months, with about 432 in interest.
- Snowball (card B first, smallest balance): clear in about 18 months, with about 493 in interest.
The avalanche saves about 60 and a month here. The snowball clears card B sooner, which some people find motivating.
Common mistake
Judging debt by the monthly payment. "Only 25 a month" sounds affordable, but on a card it can mean years of payments and interest larger than the debt. Always ask: what is the APR, and how long until it's gone?
The second mistake is borrowing on a costly card while holding savings beyond your emergency fund. Unless you need the cash to stay reachable, the card is costing you more than the savings earn.
Key terms
- APR
- annual percentage rate: the yearly cost of borrowing, including most fees
- costly debt
- debt whose rate is well above what savings earn, such as most cards, overdrafts and payday loans
- minimum payment
- the smallest amount a lender accepts each month; often mostly interest
- avalanche
- repaying debts in order of highest interest rate first
- snowball
- repaying debts in order of smallest balance first
Practise the key terms
Tap a card to turn it over. 5 cards.
| Front | Back |
|---|---|
| APR | annual percentage rate: the yearly cost of borrowing, including most fees |
| costly debt | debt whose rate is well above what savings earn, such as most cards, overdrafts and payday loans |
| minimum payment | the smallest amount a lender accepts each month; often mostly interest |
| avalanche | repaying debts in order of highest interest rate first |
| snowball | repaying debts in order of smallest balance first |
Practice
Work it through
You owe 1,800 on a card at 21.9% APR.
- 1,800 × 0.219 ÷ 12
- 1,800 × 0.219
- 40 − 32.85
Build the sentence
Using the avalanche, put these debts in the order to target with spare money (all minimums paid).
Show answer
Payday loan, about 290% a year → store card, 34.9% → credit card, 22.9% → car loan, 7.9%. Highest rate first: each spare payment then saves the most interest.
Quick quiz
Tap an answer to check it.
An advert offers "Borrow 500, repay just 30 a month!" What should you find out first?
- A low payment can hide a high total cost
Show answer
The APR and how many months it takes to repay, so you know the total cost. The monthly payment alone says nothing about the total you repay.
Why does paying only the minimum on a card take so long?
- It is charged monthly
Show answer
The minimum shrinks as the balance falls, and much of each payment is interest. A fixed payment that doesn't shrink clears the debt far faster.
A friend owes three debts and keeps giving up on repaying them. Which approach might suit them, and why?
- Missing minimums adds fees and harms their credit record
Show answer
The snowball: clearing the smallest debt first gives quick wins, which may help them keep going, though it usually costs a little more interest. The best plan is one they can stick to.
In short
- Compare debts by APR. Cards, overdrafts and payday loans are costly; clearing them is a guaranteed return.
- Card interest is roughly APR ÷ 12 each month; minimum payments can take many years.
- Pay a fixed amount that doesn't shrink, and pay every minimum.
- Avalanche saves the most interest; snowball gives quicker wins. Choose the one you'll keep to.
Mastery check
Answer without looking back. Score 80% or more and the lesson is marked done. Your result is kept only in this browser.
Check yourself
Answer in your head first, then open the answer. Nothing is saved.
What does a 2,000 balance at 18% APR cost in its first month, roughly?
Show answer
About 30 (2,000 × 0.18 ÷ 12).
You have two debts: 900 at 27% and 3,000 at 12%. Which does the avalanche target first?
Show answer
The 900 at 27%: the highest rate.
Your friend is offered a payday loan to cover a bill. What would you suggest they compare it with?
Show answer
Its total cost and APR against cheaper options, such as an arranged overdraft, a credit union loan, or asking the bill provider for time to pay.
Further reading
- UK Financial Conduct Authority, price cap on high-cost short-term credit (2015), fca.org.uk.
- Moty Amar, Dan Ariely, Shahar Ayal, Cynthia Cryder and Scott Rick, "Winning the Battle but Losing the War: The Psychology of Debt Management", Journal of Marketing Research (2011).
- Alexander L. Brown and Joanna N. Lahey, "Small Victories: Creating Intrinsic Motivation in Task Completion and Debt Repayment", Journal of Marketing Research (2015).
- Free debt advice: in the UK, MoneyHelper or StepChange; in the US, the CFPB.
- On this site: Make a budget that leaves room to save.
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