Knowing what debt to pay off first is simple when you have just one line of credit open. Budget for living expenses then make sure all of your extra cash goes towards the outstanding balance, and you’re done. But if you are like most Americans, you have much more than one debt. You have more than one type of debt as well.
Bill pay time gets a bit more complicated when you have to decide where to put your extra money and you have more than just a couple of options.
Approaching debt payoff with a carefree, cavalier attitude won’t help you make significant progress – you know this. That is why you are reading this article. You are certain that you can take charge of your debt and make it disappear, and that’s your main priority. Now it’s just a matter of figuring out HOW to actually do that and stop fumbling around in the dark with no action plan.
The following four steps can help you understand the characteristics of your debt, know which debts should be at the top of your “payoff” list and find out how to construct a personal debt payoff style that works for you. There is no one debt payoff plan that works for everyone – it depends on the amount of extra cash you’re bringing in, how dedicated you are to the debt payoff lifestyle and the total amount and type of debt you own. Keep reading to find out facts and strategies to help you prioritize what debt to pay off first on your personal financial journey.
Understand the Difference Between “Good” Debt and “Bad” Debt
You may not have realized this, but there is a stark difference between good debt and bad debt. “Wait just a second,” you’re probably thinking, “how can any debt be classified as ‘good?’”
Do you have student loans? Do you have a mortgage? Both of those types of debt can technically be counted as positive from a finance perspective. They are both investments. If you did not have an education, you would be less marketable in the job arena. You might make less or no money at all. If you did not have a mortgage, you would be wasting money every month on rent, with no possibility of a future return. Sure, you’re paying interest on both student and home loans, but much of that interest is tax deductible. You also are probably locked into installment payments that do not fluctuate much. So unless you have a majorly high-interest rate, both student loans and a mortgage are good debts.
That doesn’t mean you should not focus on paying them off. It only means if you have more pressing debts to handle, you can put those two types on the back burner while you address more serious debts in your name.
So what then is a “bad” debt? Bad debts typically have high-interest rates. Sometimes they are unsecured, meaning there is no asset to back up the value. They are a drain on your wallet and they are by no means an investment.
For instance, a bad debt could be a high-interest auto loan. Yes, the auto loan is backed by your physical car, and you might need a vehicle to get to work or school and carry out your everyday activities. However, the vehicle depreciates with every mile you drive. On the other hand, if your interest rate is high, you waste years paying off the vehicle along with paying for upkeep and maintenance so the car does not break down. In this case, it’s wise to rate this as a bad debt, placing it high on your priority list for payoff.
Another type of bad debt is obvious to most: credit card debt. The average credit card interest rate is over 14%. You can end up paying hundreds of dollars extra over the course of years if you let your balances get too high before erasing the debt. Since average American household carries $16,140 in credit card debt, it’s no simple action to just pay off the cards. If you had this much credit card debt with a 14% interest rate and you wanted to pay it off in two years, you’d have to pay over $770 a month to clear the balance, and you’d end up paying almost $3,000 extra in interest. Credit card debt is almost always a bad debt.
Knowing the difference between a good debt and a bad debt can go a long way towards helping you prioritize what debt to pay off first even though it’s not the only factor to consider along the way.
Categorize Your Debts by Interest Rates
This is a simple step. Your goal in debt payoff should be to pay the lowest amount of interest possible. If you’re only focusing on the balance, you’re missing the point.
Many financial gurus disagree. For instance, Dave Ramsey, founder of Financial Peace University and host of a popular radio broadcast on finances, says to begin by paying off your lowest balance debt first. He claims by seeing one debt completely disappear, it gives you an added psychological motivation for continuing on your journey.
But you’re not a kid – you’re an adult. You understand math. If you leave the highest interest debt for last, you’ll end up paying hundreds of dollars more towards your debt in the long run. You will also delay the time it takes to become debt free. Why would you want this? Sure, it might feel good to make your debts all go away quickly, one at a time, but wouldn’t you rather keep more of your own money? If you want a debt to go away badly enough to pay more on a higher interest debt, go for it, but it comes at a price.
Otherwise, you should sort through your debts and list them in order of highest to lowest interest rate. It’s smart to pay off the highest interest rate first – so do that. Pay the minimum on all other debts until the high interest bill is erased.
Now, integrate your considerations on good debt and bad debt as well when prioritizing what debt to payoff first, but don’t neglect looking at the interest rate, one of the most important characteristics of each debt.
Consider Both Your Short and Long-Term Goals
Every debt you have affects you, whether you realize it or not. Well, if you have lots of debt, you probably do realize it. You might be struggling to pay the monthly minimums or you might suddenly realize your credit score has taken a hit. While a monthly budget affects your day-to-day, your credit profile can and will affect your future.
Are you planning on applying for a mortgage or other type of loan in the near future? Is improving your credit score the main focus for you right now? Or are you mostly concerned with meeting your monthly obligations and keeping your budget afloat?
If you’re focused on raising your credit score, the debt at the top of your payoff list should be any line of credit that is utilizing more than 30% of the total allowed borrowing amount. Your credit utilization ratio is one of the most important factors when the financial bureaus determine your credit score. If you have a credit card that is close to being or already is completely maximized, it is vital to start paying it down right away. You will see an immediate improvement in your score in the next few months if you take this approach.
On the other hand, if you aren’t planning on needing a perfect credit score or applying for a new line of credit in the next few months, but you are concerned about your equity and your cash flow, you should consider placing saving money as a high priority along with debt payoff. To add to your cash stores, it might be smart to revert to paying off the high-interest debt first once again – that way you’ll get out of debt faster and have more money in the long run to put away into your savings account.
Tailor Your Debt-Payoff Approach to Your Personality
What debt should you personally pay off first? What’s been weighing on your mind? Would you love to pay off the final $500 on your car loan or would you rather take care of that $600 department store credit card bill? Common sense and financial sense should play into your decision, but any article or expert is lying if they say debt payoff isn’t personal. You’re the one who charged the debt. If you’re going to be the one making the commitment, you’re going to be the one to have to follow through on payoff as well.
Whatever you do, keep track of every payment you make. Use an online calculator to tally up your balances and see how extra payments can shorten the life of your indebtedness. Try making payments on a weekly basis rather than on a bi-monthly or monthly basis. Write down your goals on post-it notes and leave them on your refrigerator, mirror or anywhere else in plain sight. Every time you make an extra payment, adjust your payoff calculators and circle a new “debt-free” date on your calendar.
Also, no matter what your personal approach to debt payoff might be, one of the keys to successfully paying off any loan or credit card is to stop relying on borrowing to deal with emergencies. If you put all of your extra money towards your debt and leave none in a savings account, you will be setting yourself up for setbacks and failure. If your car breaks down, you’ll be recharging the mechanic’s bill to your credit card. If your home’s heating system goes, you may need a personal loan to fix it. Depending on the total amount of your monthly bills, try to build up an emergency fund cushion to prevent your reliance on your credit card and keep your debt payoff efforts going forward. Most experts suggest building up a 3 to 6 month’s cushion, but start with a few hundred dollars, build it up to $1,000 and continue from there.
Paying off debt is a mindset. It’s a lifestyle. It’s a commitment. You may not see major change from month to month, but as the years pass, you will see your bank account balances go from the red to the black and your credit balances return to $0. You’ll know what it takes to reestablish yourself positively in a financial sense and you will be much less likely to jump into debt again without fully thinking it through.
If you’re at the beginning stages of prioritizing what debt to payoff first, you may benefit from the advice of a certified financial advisor. You may be able to find a professional that offers a free initial consultation. Work with an advisor on a flat fee basis and you’ll be able to budget for the hourly charge. The information they may provide and strategies they can help you implement in your finances can save you serious cash, making it more than worth the cost.
This is especially the case if you are depending on credit cards or other types of loans to keep up with your regular bills. Before any more drastic damage is done to your financial state, seek help for a financial intervention and you may be able to avoid loan and debt default and even bankruptcy. Educating yourself through books, programs and blogs can also help you get back on track with your finances. Take an interest in your bills – it’s you and your family’s future that is on the line.
Use these steps to help you prioritize what debt to pay off first in your finances. Start making changes today and your future self will thank your hard work and your drive to overcome what might seem like an insurmountable obstacle right now, but will turn out to be achievable through consistency over time.