Which Debt To Pay Off First?
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If you’re looking to pay off debt, there’s a good chance you have more than one to choose from. So which debt do you focus on first? There are many factors to consider, such as interest rates, debt size, and type of debt. Another important factor is the status of your personal finances. This article will examine these factors, how they affect which debt you should pay off first, and identify some strategies to help you pay off your debts.
Written by Attorney Curtis Lee.
Updated August 16, 2021
If you’re looking to pay off debt, there’s a good chance you have more than one to choose from. So which debt do you focus on first? For example, should you start to pay off your student loan or car loan? The answer will depend on each debt’s characteristics, such as its interest rate, debt size, and type of debt. Another important factor is the status of your personal finances. Let’s examine these factors and how they affect which debt you should pay off first. We’ll also identify some strategies to help you pay off your debts.
Approaches To Prioritize Debts
Before you can pick a debt to pay off, you need to review all of your debts to determine what kind they are and what their terms are. But before you can do that, you need to understand what debt is. Debt is money that you borrow now and pay back in the future. For most consumer debts, the borrowed money gets paid back over time. The borrower must usually pay back more than they borrowed. This extra money is interest.
In the United States, there are two major types of debt: revolving debt and installment loans. The most well-known form of revolving debt is a credit card account. Revolving debt allows an individual to borrow money, but the borrower isn’t required to pay off the entire balance by a specific deadline. Instead, the borrower makes regular payments of a minimum amount at regular intervals. Revolving debt also allows the borrower to continue borrowing money, even with an outstanding balance. Most forms of revolving debt will have a credit limit and charge interest on any outstanding balance.
An installment loan is a type of debt where you borrow all of the money for the debt at one time. Then at some point in the future, you pay back the debt in installments. Often, these installment payments take place each month. Examples of installment loans include:
Now that you understand the two main types of debt, you can look at each one and examine its characteristics. The next few sections will discuss a few of the more important factors and how they can affect which debt you start paying off first. But before you decide which debt to pay off first, you want to see if there are any debts you don’t want to pay off first.
For instance, certain interest paid on a home mortgage is tax-deductible. So it might be best to pay off this debt later to take advantage of this tax benefit. Then there’s the fact that many federal student loans are subject to coronavirus-related student loan relief. This allows borrowers to pay no interest and make no payments until at least September 30, 2021.
Finally, certain student loans are forgivable, like those eligible for Public Service Loan Forgiveness (PSLF). This program forgives any Direct Loan balances after a borrower has made 120 qualifying monthly payments while working for a qualified public interest employer.
A debt’s interest rate might be the single most important thing to look at when deciding which debt you should pay off first. So when organizing your debts to pay off, list them in order of their interest rates.
One thing you’ll notice is that debts that are easier to discharge during bankruptcy will have higher interest rates. If you have any outstanding credit card balances, they’ll probably have the highest interest rates of all your debt. Your student loans and home mortgage loan will probably be among your debts with the lowest interest rate.
One thing to keep in mind: Just because a debt has a high interest rate, that doesn’t automatically mean you should pay it off first. You should also consider if there’s a penalty for paying the debt off early, if the debt is forgivable, and if there are tax consequences for paying off the debt.
Secured Debts vs. Unsecured Debts
A secured debt is a debt that has collateral to protect the creditor in case you default on the loan. If you stop making payments, the lender can take the collateral away from you. Common examples of this include getting your car repossessed or your home foreclosed.
An unsecured debt is a debt that isn’t protected by collateral. So if you default on an unsecured loan, the creditor has no property they can go after. This makes these debts riskier for the creditor. Because of this higher risk, unsecured debts usually have higher interest rates and will be more expensive for you in the long term. If you default on an unsecured loan, a debt collection agency might try to recover the debt from you.
Size of Balance
Another approach to deciding which debt to pay off first is to look at the size of the debt balance. For some people, it might make more sense to focus on the smaller balances first. One of the benefits of this approach is that it can provide the psychological boost of paying off a debt more quickly than if you started with a larger debt.
Payment history is one of the largest components of your credit score. So when deciding how to prioritize your debts, you want to do so in a way that prevents a missed payment. Missing a payment is one of the quickest ways to hurt your credit history. For example, if you have a debt with a small minimum monthly payment, there’s a smaller risk of defaulting on that debt. So it might make sense to pay off that debt after you pay off a debt with a higher minimum monthly payment.
Debts with larger minimum monthly payments are sometimes prime candidates to pay off first. One reason for this is that they put you at a greater risk of missing a payment. Another reason is that paying off debts with higher monthly payments first allows you to free up more cash to tackle your remaining debts.
In deciding which debt to pay off first, assess who your creditor is. If it’s a friend or family member, what happens if you default on that debt? Could it put a strain on your relationship with that person? If so, it might be best to pay off this debt first to avoid an uncomfortable situation.
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Pay Off Strategies
After you decide which debt to pay off first, you’ll want to find the best debt payoff strategy. Deciding on a strategy will depend on the debt characteristics discussed above, as well as your personal preferences. Regardless of which strategy you choose or which debt you decide to pay off first, one thing to remember is that you need to pay your absolute necessities first. These include costs like:
Debt Avalanche Method
The debt avalanche method focuses on paying off your high-interest debt first. To use the debt avalanche method, make a list of all your debts and rank them in terms of their interest rates. Find the debt with the highest interest rate and pay as much as you can toward that debt. With your remaining debts, make only the minimum payments. After your debt with the highest interest rate gets paid off, go down your list, find which remaining debt has the highest interest rate, and repeat the process.
The primary advantage of the debt avalanche method is that it’ll help reduce the amount of money you spend on interest. The drawback of the debt avalanche method is that it may take longer to pay off your first debt. This might make it easier to get discouraged during your debt payoff process.
Debt Snowball Method
The debt snowball method is similar to the debt avalanche method except that instead of starting with your debt with the highest interest rate, you start on your debt with the lowest balance. After the smallest debt is paid off, you use the money that would have gone to pay your smallest debt to help pay your next smallest debt. As you repeat the process, your payments snowball until all your debts get paid off.
The debt snowball method is popular because it provides a psychological boost. The literal and mental payoffs happen more quickly than they do with the debt avalanche method. Paying off debts is as much of a psychological challenge as a financial one. So the ability to see the positive results soon has its advantages. But this advantage comes at a cost. The debt snowball method is often more expensive in the long run because your smallest debts aren’t always going to be your debts with the highest interest rates. An additional drawback is that it can take more time to become debt-free.
Because your financial situation is unique, it’s possible to come up with a debt repayment plan that fits your one-of-a-kind needs. For instance, instead of focusing on a debt’s interest rate or amount, you might take a triage approach. This might consist of paying off debts that are in the collection process instead of debts in good standing. Then there are the more popular debt repayment strategies.
One of the most popular is getting a debt consolidation loan. In this process, you combine several debts into a single loan. Debt consolidation isn’t for everybody, but it can be a useful tool to make paying debts easier and cheaper. There are several ways you can consolidate your debts.
First, there’s the balance transfer credit card. Many credit cards will offer new or existing customers the option of transferring one or more credit card debts onto a credit card with a low or 0% promotional interest rate. This promotional rate may last anywhere from a few months to more than a year. This can buy you time to make progress on your payments without more interest accruing. After the promotional interest rate ends, any remaining balance will be subject to the normal interest rate for that credit card account.
Second, you can apply for a personal loan with an interest rate that’s lower than two or more of your existing debts. After you get approved, you take the proceeds from the personal loan and use it to pay off your debts with higher interest rates.
Third, you can take advantage of the equity in your home by applying for a home equity loan or home equity line of credit (HELOC). Key benefits from this form of debt consolidation are that the interest rates are often lower and you could have a large amount of available credit. But a potential drawback is what happens if you default. In that situation, your home could be subject to foreclosure.
Deciding which debt to pay off first requires you to list your debts and identify key parameters of each one. This includes things like the debts’ interest rates, debt balance, minimum payments, and lenders. Based on these parameters, you can then decide which debt payoff strategy to use. Your chosen debt payoff strategy will help decide which debt you should pay off first. To help you with debt relief, including finding the right strategy to meet your needs, it might be worth looking into credit counseling.