Paying off debt can be trickier than it sounds. Many people have a mix of debt that ranges from student loans and credit cards to auto loans and mortgages. In the long term, it pays off to know where to start and what loans you should prioritize repaying.
Hone in on high interest rates
As a general rule, it is advisable to rank all of your loans based on interest rate. Plan to repay those with the highest interest rates first, even if the balance is lower, as the debt load on these loans can grow very quickly. “It costs more to carry a balance on a high interest rate credit card. That’s because your monthly finance charge is based on your interest rate and your balance—the higher your interest rate, the higher your finance charge will be,” writes LaToya Irby in a June 2016 article for TheBalance.com.
“The longer you take to pay off the card, the more money it costs you because you pay more in finance charges when you pay the debt off slowly. Paying off high interest rate debt first saves money and usually lets you pay off the debt faster.”
Remember the necessities
Falling behind on any loan payment is never ideal, but it is even worse if it is a mortgage payment, auto loan or utility payment. Missing too many of these may lead to creditors foreclosing on your house, repossessing your car or shutting off your utilities. Fortunately, these loans tend to have lower interest rates than other types of consumer debt, such as credit cards, which means you should try to pay off only the minimum necessary, allowing you to focus on other, higher-interest debt.
Furthermore, having a mortgage or student loan isn’t inherently a bad thing. “Money you borrow for a home or an education is considered ‘good debt.’ That’s because these items can help boost your financial position,” write Time Magazine’s ‘Money’ editors. “In addition, some home and student loan debt may be tax-deductible. There’s no need to put pressure on yourself to repay those loans as long as you can continue making regular installment payments.”
Don’t neglect psychological boosts
Mathematically, it makes more sense to put $500 toward a $4,000 credit card bill with an 18 percent interest rate than it does eliminating a $500 bill at 6 percent. However, in some cases you may find it more beneficial to pay off a loan with a low balance because the feeling of getting that bill off of the debt list can be a powerful motivating factor.
“The first balances are easier and quicker to pay off,” Irby writes in an August 2017 article for TheBalance.com. “When you finally pay off a bill, the feeling of accomplishment is motivation to keep you going.”
Additionally, quickly getting low-balance debt out of the way can help simplify the process of making a loan repayment plan and free up some money that you can better allocate elsewhere.
Consider the impact on credit score
Plan to eliminate certain debt, such as that accrued from credit cards, as quickly as possible—and not just because it comes with a double-digit interest rate. “Unlike student loan and mortgage debt, the best strategy for credit card balances is to get rid of them as quickly as you can,” writes Daniel Kurt in a May 2015 article for Investopedia.com.
Prioritizing credit card debt can help keep your credit score healthy. If your credit cards are maxed out, it is important to lower your credit utilization as soon as possible. Generally speaking, you should try to borrow no more than 30 percent of your total available credit. “In addition to ridding yourself of a big interest charge, ditching credit card debt will likely also improve your credit score,” Kurt says. “About a third of your all-important FICO score is tied to how much you owe creditors—and revolving credit card balances are weighted against you even more than other types of debt.”
Don’t let your debt overwhelm you—work with your financial advisor to plan out the best way to get debt-free as soon as possible.