Categories

Debt

Which Debts Should I Pay Off First?

If you're dealing with a lot of debt, it can be hard to know how to start tackling it. While it's generally recommended to first pay down your high interest debt, the right strategy for you can depend on your situation.

Regardless of which approach you take with your debt, the most important thing you can do to become debt-free is to create a plan and follow through with it.

Should You Pay Off Installment Loans or Revolving Credit First?

Debt is usually broken down into two groups: installment loans and revolving credit. Here's how each works:

  • Installment loans: Installment credit comes in the form of loans that have equal monthly payments—often called installments—over a set repayment period. For example, when you get a 30-year mortgage loan, you get a lump sum to cover the cost of the sale, then the loan is paid off over that time. So you know exactly what you're going to pay every month and when the loan will be paid in full.
  • Revolving credit: The alternative to a lump-sum loan amount, revolving credit accounts give you a line of credit that you can draw on, pay off and use again. Credit cards and lines of credit are considered revolving credit. Lines of credit typically have a draw period, followed by a repayment period, similar to an installment loan. With credit cards, however, there's no set repayment period and your monthly payment is based on a percentage of your balance.

The decision of which type of debt to pay off first depends on a few things, so it's important to understand the full extent of your situation.

Interest Rates

Again, the general recommendation is to focus on the debts with the highest interest rates. In many cases, that's going to be credit cards. But for the most part, credit card interest rates max out at roughly 30%, and some traditional personal loans go as high as 36%.

If you have a personal loan for bad credit, payday loan, auto title loan or something similar, your annual percentage rate (APR) can be in the triple digits. So, take stock of all of your debts and how much they're costing you to decide which one to tackle first.

Loan Terms

The urgency of your debt situation is another important factor to consider. For example, if you have five years left on your auto loan, you won't run into any problems if you just continue making the regular monthly payment for now while you focus on other debts.

But if you have a payday loan, auto title loan or short-term personal loan, a delayed payoff could have drastic consequences, including damage to your credit score and more debt. In fact, the Consumer Financial Protection Bureau found that 80% of payday loans are rolled over into a new loan (re-borrowed) within a month, and nearly a quarter are rolled over at least nine times.

With auto title loans, not paying back the debt on time can result in the lender repossessing your vehicle. So if you have these types of loans, focus all of your efforts on paying them off as soon as possible so you're not out of a way to get to work.

Your Spending Habits

If you've racked up a lot of credit card debt through overspending, the longer you keep those accounts open, the higher the chances are that you'll continue racking up balances. In this scenario, it may be better to pay down your credit cards quickly and then close the accounts, even if you have a personal loan with a slightly higher interest rate.

Which Credit Cards Should You Pay Off First?

If you've decided to focus on your credit card debt first, and have multiple accounts, prioritize the card with the highest interest rate to save more money on interest.

To maximize your savings, use the debt avalanche method: Make just the minimum monthly payment on all of your cards except the one with the highest interest rate. With that account, put all of the extra money you can afford to pay it down faster.

Once you've paid off the balance on the card with the highest interest, take all of the money you were putting toward it every month, and apply it to the card with the next-highest rate in addition to the minimum payment you're already making. Again, you'll continue to pay just the minimum on your other cards.

You'll repeat this process with each card until all of your credit card debt is paid off. The strategy is called the debt avalanche method because your payments will increase with each successive card, accelerating your progress more and more.

Another way to approach your credit card debt is with the debt snowball method. This approach works mostly the same as the debt avalanche method with one key difference: Instead of focusing on your balance with the highest interest rate first, you'll pay down your smallest balances first.

This approach won't save you as much money as the debt avalanche method would. But if you've struggled to get and stay motivated with debt payoff, getting quick wins in the form of paid-off accounts can help you keep that momentum going.

Consider Refinancing Options to Save More Money

As you're paying down your debt, consider whether there's a way to refinance some of your debt at a lower interest rate. This may be possible if your credit has improved since you first took out the debt. And if you have good credit, you may be able to qualify for a balance transfer credit card with an introductory 0% APR promotion.

Check your credit score and look into opportunities to consolidate or refinance your high interest accounts with a lower interest option. This process alone won't solve your debt problem, but it can make it easier to manage, save you money and help you become debt-free sooner.

Resources