6 Points to Consider When Deciding Which Debt to Pay Off First
Which debt should I pay off first––my credit cards or student loans?
Or...
Should I pay off my mortgage before or after paying off other debts?
These type of questions are common for most of our clients dealing with debt. So, today's article is about which debt to pay off first so that we can help our community.
The answer is not easy. First, you have to understand the specific type of debt you have incurred.
Not all debts are harmful, meaning some, you can take your time to pay off.
In addition to this, when you are deciding to pay off your debts, you have to consider your current financial position, debt load, and motivation.
Here are 6 points to consider when deciding which debt you should pay off first.
1. Understand the type of debt you have
To understand which debt to pay off earlier, you should know your debt type first.
Types of debt:
Secured debt: This debt is guaranteed by collateral. A creditor or lender will offer you a loan guaranteed by the collateral. Example: home loan, auto loan.
Unsecured debt: This debt isn't backed by an asset or collateral. Examples: Credit card debt, medical debt, utility bill, and loans or credit without a collateral requirement.
Fixed interest rate debt: This debt has the same interest rate for the whole loan life. Example: FRM (Fixed Rate Mortgage).
Variable interest rate debt: This debt has no fixed interest rate. It can change over the life of the loan. Example: Credit cards.
Tax-deductible debt: This loan should be used for betterment. It gives tax benefits. Example: Mortgage loan, student loan.
Knowing the debt type is important to understand what kind of debt you are dealing with. For example, a secured debt like a home loan and a tax-deductible debt like a student loan are considered "good debt". They are tax-deductible and boost your financial position.
You don’t need to hurry in repaying these types of loans as long as you are making monthly installment payments.
Some debts are considered to be bad debt like credit card debt or a personal bank loan. These debts are unsecured and don't improve your financial position.
You should repay the debt within the time otherwise you will accumulate more debt in the form of costly interest rates.
2. Identify which debt is costing you the most
It is always wise to get rid of the highest interest rate debt first. If you have multiple credit card debts, you should target the credit card debt with the highest interest rate first.
Try to make the minimum payments on every debt while making a large payment toward the highest interest rate debt every month.
By doing so, you can pay off the highest interest debt soon and move ahead to the next highest interest-bearing debt.
Stick to the method until all your debts are paid off. This method is known as the debt avalanche method.
NerdWallet columnist Liz Weston quoted that "With the help of debt avalanche method, you’ll get out of debt more quickly by going after toxic debt first.”
3. Closely monitor your credit score while taking out a loan
"Paying down the debt" scenario comes after the "taking out the loan" scenario. It’s important to play a safe game while you are planning to take out a loan. Thus, you will pay off your debt without getting confused.
For example, If you are planning to buy a home or car, you should check your credit score first. Why? Because lenders will offer you an interest rate based on your credit score.
If you have a good to excellent credit score, chances are high that you’ll receive better terms and lower interest rate.
If your credit score is bad to average, your loan application may get rejected or the interest rate may be higher. And a higher interest rate loan means you have to pay more money for a longer time.
4. Be smart about interest rates
It is true that the high-interest credit card debt can cost you more money and you should pay them as soon as possible.
But you shouldn't borrow money from your retirement savings (401k) or take out a home equity loan to pay off your "bad debts". If you borrow from your retirement fund, you can miss the valuable tax benefits.
On the other hand, defaulting on the home equity loan will cause you to lose your home. Thus, you should find out other options to pay off your "bad debts" first instead of making your financial position more intense.
5. Start with the lowest balance first
The process of debt repayment can overwhelm you. To stay focused, you can pay off the lowest balance first. This will help you to build a sense of confidence in your plan. You can start with the debt snowball method to pay off the lowest balance first.
In this method, you’ll need to make an extra payment to the lowest balance debt while paying the minimum to the rest.
Once the lowest balance debt is paid off, target the second lowest balance on the list, and so on. The first win will make you feel great.
6. If you are not sure, seek professional help
If you have multiple debts including good debts, bad debts, and worst debts (payday loans), and you are not sure where to start, then seek professional help to get the best advice.
You can consider a credit counseling session to get the idea about the best-suited debt repayment strategy. (Our Certified Debt Experts can help)
Lastly, regardless of which plan you consider, it is important to stick to the plan in order to see success. Once you decide on a repayment strategy, plan your budget accordingly. This allows you to stick to the plan while taking care of your mandatory expenses. Remember, paying off debt is tough, but doable if you have the right plan in place with the right support.