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Are you weighed down financially with debt? Are you looking to start turning around your finances, but aren’t sure which debt you should pay off first?
The short answer is, the answer depends on your circ*mstances. Below, I plan on laying out the information necessary for you to make the most informed decision for your circ*mstances.
Table of Contents
Pay Down High Interest Debt First
As a general rule of thumb, it makes sense to pay down thedebt with the highest interest rate first.The way you would do this is pay the minimum for all of your debts tokeep them current, then dedicate any remaining revenue towards paying off theone debt that has the highest interest rate.
Debt Snowball – Why I Don’t Recommend It for Everyone
You’ve most likely heard of Dave Ramsey and hisrecommendation for debt repayment, the debt snowball. Essentially, this debt repayment method revolvesaround paying down the smallest debt first.This works really well for those that have a hard time staying motivated.
This method works because it keeps you motivated to continuewith your debt repayment because you start seeing what looks like more progresstowards your debt repayment sooner.
I personally think that most rational people are capable ofkeeping themselves motivated towards a goal if they have a plan from theoutset. This is especially true withautomatic payments that you can setup once and forget it.
Sure, it may take a little longer to see significantprogress towards any one debt, but you will ultimately pay off all of your debtfaster and will pay less in interest charges.
Good Debt Versus Bad Debt
There are two types of debt:good debt and bad debt.
Good debt is any debt used to improve your financialsituation. This includes student loans,mortgages, etc. Good debt often comeswith the added benefit of a tax deduction.
Bad debt is debt that isn’t related to improving yourfinancial situation. This includes creditcard debt, personal loans, etc.
All things being equal, you should focus on paying down baddebt before good debt to take advantage of any tax breaks that are available.
Secured Versus Unsecured Debt
Two other classifications of debt are secured and unsecured debt. In a nutshell, secured debt is backed up with collateral. For example, a mortgage is secured because it is backed up by collateral in the form of a house (an asset). Another example would be a car loan as it is backed up by a car (another asset).
Unsecured debt like credit cards, personal loans, etc. aren’t backed up by any assets. This means that if you miss payments, they don’t have an asset to repossess to help pay down the debt.
All things being equal, you should focus on paying down secured debt for the things necessary to survive and generate income (car, home, etc.) before paying off unsecured debt.
Some Other Debt Repayment Considerations
Debt Repayment Flexibility is Important
Some debt has more inherent options for repayment thanothers. For instance, student loans canbe deferred or even forgiven altogether if you meet certain circ*mstances.
Also, when it comes to bankruptcy, some debt can be removed,while others will remain. For example,credit card debt, personal loans, home mortgage, etc. will be removed throughbankruptcy (along with your assets). Onthe flip side, your student loans, any money you owe to the government (taxes,fees, etc.), alimony, etc. will remain even after bankruptcy.
Each Debt Affects Your Credit Score Differently
Not all debt is created equal as it relates to your creditscore. While you should always try tokeep your total debt to a minimum, you also need to be careful about the ratiobetween the original loan amount and current balance on your loans as well asyour credit card utilization ratio.
If you have a large purchase in the near future that requires credit like a car or home purchase, make sure to consider your credit card ratio. Ideally, you should aim for a credit card utilization ratio under 30% (the lower the better).
Most of the time your credit card debt will have the highest interest rate, but if it doesn’t and you’ll need credit soon, you may want to consider paying back credit card debt first to get the best terms and conditions on your purchase.
Carefully Consider Consolidating and/or Refinancing Your Debt
Consolidating or refinancing your debt is a great way to getmore favorable terms on your debt, especially if your debt has very highinterest rates like credit cards or pay day loans.
The key is making sure that the terms are actually morefavorable.
Does the consolidation or refinance extend the life of the loan? Do you end up paying less now, but more over the life of the loan? Does the interest start off favorable, but either adjust or balloon over time?
Be very careful when considering these options because there are companies out there that will take advantage of you and your situation.
Don’t Trust Debt Settlement Companies
Debt settlement companies often promise to negotiate withyour creditors to decrease your debt or to achieve more favorable terms foryour debt repayment. The caveat is thatthey often charge a fee and don’t do anything that you can’t do yourself.
If you’re in a bad situation where you’re falling fartherand farther behind, call up your creditors and see if you can negotiate morefavorable terms yourself. Be honestabout your situation and describe ways in which you’re working to improve yourfinancial situation.
If you go bankrupt, the unsecured debt that isn’t protected by bankruptcy law will end up being wiped away, so it’s in your creditors’ best interest to work with you if they want to recover their money.
Don’t Borrow from Your Retirement to Pay Off Debt
Do not borrow from your retirement plan if you can help it. Unless you’re using the money for a qualifying use (school, first home, etc.) for your plan, you’ll pay significant penalties, fees, and taxes on your retirement withdrawal.
Don’t Use Home Equity Loans to Pay Down Debt
For most people, their home is their biggest asset. If you borrow money against your house, you run the risk of losing your house if you’re unable to pay back the loan. Do you really want to gamble away your biggest asset?
Conclusion: So, Which Debt Should You Pay Off First?
For most people, you’ll either pay down the debt with the highest interest rate or pay down the smallest balances first (debt snowball). From a financial standpoint, paying down the debt with the highest interest rate is by far the best strategy. However, if you have a hard time staying motivated and think you’ll do better with quicker wins (paying off individual debts faster), you should practice paying down the smallest balances first.
Each situation is different, so if you’ve done your researchand are still unsure, you should consider talking to a financial advisor (preferablyfiduciary) about the best course of action for your circ*mstances.
What debt repayment method do you prescribe to? What debt did you/are you paying off first? Any stories and/or advice about debtrepayment from your personal experience?
