Which debt should you pay off first?
If you have debt on multiple credit cards or loans, you are not alone.
Americans with credit cards have an average debt of $ 5,315, according to a 2020 Experian report, and that doesn’t include additional debt, such as mortgages, car loans, and student debt. Many consumers try to pay off multiple credit accounts at the same time.
With all of these outstanding balances, which debt do you need to pay off first? While you should always make at least the minimum monthly payment on every debt you owe, it can be difficult knowing how to prioritize the extra debt repayment dollars each month.
While paying off your highest debt is a common strategy first, there are benefits to tackling your smallest debt first, regardless of interest, and working your way to the top. ‘to your highest debt. Let’s take a look at how to choose which loan to pay off first, as well as the pros and cons of various debt repayment scenarios.
Option 1: Pay off the debt at the highest interest rate first
There’s a good reason to pay off your debt at the highest interest rate first: it’s the debt that charges you the most interest. Credit cards with above-average APRs can be particularly difficult to pay off, and anyone with a student loan or mortgage experiences the frustration of making monthly payments that only go towards interest, not principal.
If you want to get rid of that high-interest debt as quickly as possible, start by focusing your repayment efforts on your highest-interest debt. This is commonly referred to as the avalanche method. Continue to make the minimum monthly payments on all of your credit cards and loans, but invest every extra penny you can toward the card or loan with the highest interest rate. If you need help, here’s a list of five steps to help you pay off your debt as quickly as possible.
While focusing on your highest interest rate debt first is a smart move, it isn’t necessarily the best option for everyone. If you’re making monthly payments on a lot of debts, for example, you might not have a lot of extra money to spend on your highest-interest debt. The avalanche method can also be overwhelming if you have a large debt, as paying it off can seem impossible.
Option 2: Pay off the smallest debt first
While some people choose to pay off their debt based on the interest rate, others pay off their smallest debt first and progress to the largest. This method of paying off debt, popularized by finance guru Dave Ramsey, is called a debt snowball because it starts out small and grows over time.
The snowball method works because paying off a debt in full keeps you working toward your goal – and as you pay off your small debts one by one, you’ll have more money to spend on your bigger ones. big debts. You might end up paying more interest than if you had tackled your highest-interest debt first, but the psychological benefits of paying off those small debts as quickly as possible can be very rewarding.
To get started with your debt snowball, list all of your current debts – and their current balances – from low to high. Continue to make the minimum monthly payment on all of your debts while putting as much extra money as possible on your smallest debt. Once that debt is paid off, spend your extra money on your next smallest debt, and so on. The more big snowballs you accumulate, the closer you get to debt freedom.
Option 3: Why You Should Focus On Your Credit Score
To understand the impact of credit scores on your life, think of your credit score as some kind of financial blood pressure. It requires monitoring, especially if finances seem incompatible with your lifestyle. Your credit score can help lenders understand how or not you are on top of your finances. It depends on how much debt you have, how many open lines of credit you have used, and your payment history.
For larger purchases like a new home or a new car, your credit rating and use of credit will need to be favorable. Your credit usage – the amount of your available credit compared to what you are using – must be less than 30% and your accounts must be up to date. Any default will force a mortgage loan officer, or any lender, to reconsider whether to offer you a loan.
If you have a clean credit image, banks and other financial institutions will likely view you as a less risky borrower. You’ll also have more opportunities to get lower APRs and zero-down deposits. Your credit cards might receive spending limit increases, and your financial institution might come up with some great offers to keep your business accountable.
Focusing on your credit score might require lifestyle changes to start reducing your debt. You may see the change in your habits, like removing daily take-out lunches and impulse shopping, as a huge hurdle. Since part of your income will have to go towards your debts, you could lose your motivation. However, giving up some comforts can reduce your debt load and improve your credit score.
Option 4: Use a balanced method
Tackling your biggest debt might seem like too big a financial feat. Small debts can wait compared to more urgent circumstances, such as debts that have fallen into collection. Debt that qualifies you for tax deductions for the interest you pay – like a student loan or home equity loan used to “buy, build, or significantly improve” your home – can also go down in order of importance. .
What can you do in these scenarios? Take a balanced approach that’s uniquely yours. You can incorporate any of the three debt repayment options we have mentioned, in any order or manner you want. For example, you can eliminate a collection debt before you pay off your credit card, by making only minimum payments to your other accounts in the meantime.
Consider debt consolidation
If you want to consolidate your debts into a single monthly payment, several options are available to you. You can transfer your existing credit card balances to a balance transfer credit card, many of which come with long introductory 0 percent APR periods. Major balance transfer credit cards offer between 15 and 21 months of 0% APR on balance transfers, giving you ample time to start paying off your debt without paying interest on your transferred balance.
You can also take out a personal loan and use that money to pay off high interest debt. Yes, you will still have to pay off your personal loan, but if you can find one that offers significantly lower interest rates than what you are currently paying, this could be a way to lower the overall cost of your loan repayment process. debt. Use Bankrate’s Debt Consolidation Calculator to find out how much you could save by taking out a personal loan.
Finally, you might consider consolidating your debt with a home equity loan or home equity line of credit. Bankrate’s home equity calculators can help you determine if using your home equity to pay off debt would save you money in the long run. Remember, if you fall behind on your mortgage payments, you run the risk of foreclosure. So think carefully before taking out a second mortgage to pay off other debts.