Why it matters which order the balance is paid off

Credit cards can be a convenient way to borrow money. However, these cards should be treated with care and it really does matter how the accounts are structured. One important element of this account structure which doesn’t often get the attention it requires is the order in which the card balances are paid off, also called the payment hierarchy.

Although it can look confusing at first, it is actually simple. Most credit cards charge different interest rates on different balances which have been accrued in different ways. For example, a card may have a total balance of $4,000. But $2,000 of that balance might have come from a balance transfer from a credit card with a higher interest rate, $1,000 from spending, and another $1,000 from cash withdrawals through an ATM.

These three balances are likely to be charged interest at different rates. To continue the hypothetical example, the balance transfer may be charged interest at 10%, the spending balance at 15%, and the cash advance at 20%. (Cash advances are usually charged interest at a higher rate than any other balance on the card).

Clearly then it does matter how the balances are paid off. However, too many people continue to assume that it’s unimportant. But if the balances with the highest interest rate are reduced first, then the interest suffered will be considerably less. Another fallacy is that the balances are paid off proportionately or in a last-in-first-out basis. This is also not generally true.

The credit card company will tend to apply all payments received to the balance carrying the lowest interest rates first, before those carrying higher rates. This means that the average interest rate on the credit card will rise over time, as the lower rate balances are discharged while those with the higher rates last longer and accumulate more interest charges on the card.