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You’re finally ready to tackle your credit card debt, and you’re feeling optimistic. You could try the debt snowball method! Or the debt avalanche method! But later, when you’re making credit card payments, you realize it’s not that straightforward.
When you look at the first page of your credit card statement, or at the top of your account online, you might see your debt displayed as one big number. But depending how you've used the card, a closer inspection might reveal that it’s split into separate balances, such as:
What’s more, these balances may each have different interest rates. So when you make a payment on an account with multiple balances, where is that money going? Your issuer isn't going to call you and ask how you want it handled. Instead, it will distribute your payment among your balances in a way that conforms to federal law.
Basic rules of credit card payment allocation
It would be nice, in most cases, if the law required that 100% of your payment go toward your most expensive debt. That’s exactly what an early draft of the Credit Card Act proposed. But the version that eventually became law gives credit card companies a little more leeway in divvying up your payments.
Generally, your issuer divides your credit card payment into two parts:
The minimum payment is the portion of your balance you’re contractually obligated to pay each month. The issuer can apply the minimum to whichever balance it wants. Often, this means the minimum goes toward the lowest-interest balance, rather than your most expensive one.
The excess payment is everything you pay above the minimum. The Card Act requires issuers to apply this part of your payment to the highest-interest balance first. After that, the remainder generally must be applied to the other balances in descending order, based on the applicable annual percentage rate, according to the law.
How does paying off a credit card work in practice? Let’s say you have a card with the following balances:
$640 of balance transfers at 0% APR
$60 of cash advances at 25% APR
$300 of purchases at 15% APR
Suppose your minimum payment was $25, but you opted to pay $100 instead. Here’s how your issuer might allocate your payment:
$25, the minimum payment, might go to balance transfers, since it has the lowest APR.
$60 might go to cash advances, which has the highest APR.
$15 might go purchases, which has the second-highest APR.
Before interest charges were added, the remaining balances would be as follows:
$615 of balance transfers at 0% APR
$0 of cash advances at 25% APR
$285 of purchases at 15% APR
The deferred interest exception
Most of the time, having your issuer apply your excess payment to the highest-interest balance is the most cost-effective option. But the Card Act makes an exception for deferred-interest offers, often found on store cards and medical cards. That's because leaving those "no interest if paid in full" balances for last can have expensive consequences.
Deferred interest is different from the 0% APR offers you see on bank credit cards. Here's how:
With a 0% APR card, you are not charged any interest during the 0% period. That interest is waived entirely. Once that period is up, you can be charged interest only on outstanding balances going forward.
With a deferred-interest offer, by contrast, if you have not paid off the purchase in full at the end of the interest-free period, you will be charged retroactive interest going back to the original purchase date.
Suppose you buy a $1,000 washing machine on a store card that promises no interest on that purchase if you pay it off within 12 months. That card has an ongoing APR of 24%. If you haven't fully paid off the washer at the end of 12 months, you'll be charged interest on it starting on the day you made the purchase — $155.27 in retroactive interest, according to a report from the National Consumer Law Center.
Now say you have multiple balances on that card — because you continued to use it at the store, making purchases that did not have deferred interest — and have been making only partial payments. In that case, avoiding retroactive interest would be almost impossible. That's because the Card Act requires your issuer to apply most of that money to your highest-interest balances, not your deferred-interest balance.
Enter the Card Act's exception for deferred interest cards. This rule stipulates that in the two billing cycles before a deferred-interest offer expires, the issuer must apply any amount paid over the minimum payment to the deferred-interest balance first. This exception makes it slightly easier to avoid retroactive interest. But it doesn't make you immune from such charges, so stay vigilant. Read your statements and make sure you're on track to pay off your balance on time.
Avoid credit card payment allocation problems
There are a few ways you can exercise more control over your credit card balances:
Don’t ask your cards to multitask. Nip all of your payment allocation problems in the bud by carrying just one balance on each credit card. First, move your debt to a 0% balance transfer credit card, if you can qualify for one, and use it as a “just for debt” card. Then, use a separate card for purchases, and pay it off in full each month to avoid interest charges.
Pay as much of your bill as you can afford. If you can’t qualify for a balance transfer credit card, the next best thing you can do is pay down as much of your credit card debt as you can afford. This ensures that a larger portion of your payment will go toward your most expensive balances. When you pay just the minimum, it allows your issuer to direct your payments to your least expensive debt, prolonging your repayment period.
Trust, but verify. These days, a computer — not a human — is allocating your credit card payments. For the most part, that means you won’t have to worry about fat-finger billing errors and misapplied payments. But errors still happen. Read your credit card statements closely and make sure your payments are being applied as they should be. If you think there’s a mistake, call your issuer and address the problem as soon as possible.