Debt is not created or managed in the same way
The best way to pay off debt differs from person to person. In fact, which debt you should pay off first is determined by your income, expenses, and other responsibilities, such as being financially responsible for minor children or elderly parents.
Whether you have a mountain of debt or only a few credit card balances to pay off, how and when you pay off your debt is determined by your unique circumstances. Here's how to figure out which debt should be paid off first.
Important Points to Remember
- There is no "right" way to pay off debt because each borrower's situation is unique.
- To protect your assets, it may make more sense to pay off secured debt before unsecured debt.
- According to the interest rate and balance size, there are several tried-and-true methods for paying off credit card balances.
- You should pay off the debt that is causing you the most stress first.
Types of Debt
While all debt is defined by the amount of money owed, there are several types of debt. Installment loans, for example, are one-time loans that you take out and repay in monthly installments over a period of months or years. Instead of making a lump-sum payment, revolving debt is a balance that you can borrow from. You can borrow at any time instead of borrowing once and making payments as with an installment loan.
Installment loans include the following:
- Home equity loans and mortgages
- Loans for automobiles
- Loans for students
- Loans for individuals
Revolving debt includes:
- Credit cards
- credit line secured by your home
- credit line for individuals
In addition, there are two types of debt: secured and unsecured debt. Unsecured debt isn't backed by anything, whereas secured debt is. If you default on a secured debt, such as a mortgage or car loan, your lender has the right to repossess your collateral.
Despite the fact that unsecured debt does not require collateral, making a payment that is more than 30 days late can harm your credit score and your ability to borrow in the future.
It's important to know whether your debt is secured or unsecured because it can affect which debt you pay off first. For example, if you recently purchased a home,one of the most significant purchases of your life—you will most likely not be able to pay off your mortgage right away. If you recently graduated from college and are only making minimum payments on your student loan, you may want to consider increasing your payments to pay off your debt faster. It's also a good idea to pay off secured loans first so you don't lose your collateral.
Debt divided by the interest rate
The interest rates you pay may also influence which debts you should pay off first. A credit card with a high APR, for example, will take a long time to pay off because interest accounts for a large portion of your monthly minimum payments.
You could use the "debt avalanche" method to get rid of high-interest credit card debt. You'll use this strategy to pay off the loan with the highest interest rate first while making minimum payments on your other debts. Put the extra money you used to pay off your highest-interest debt toward the card with the second-highest interest rate once your highest-interest debt is paid in full. Carry on in this manner until you have paid off all of your debts.
The debt avalanche method is a good strategy for people who want to pay off high-interest debt quickly, even if the results aren't immediate.
When deciding which debt to pay off first, interest rates are only one factor to consider. Paying off your smallest balances first to gain momentum, or paying off an overdue balance that may go into collections soon, may be a better option.
Balances and Terms of Debt
While the debt avalanche method may save you more money, the "debt snowball" method may be preferable. Instead of focusing on interest rates, you prioritize paying off your smallest debt first while making minimum payments on your other debts. After you've paid off the smallest debt, put that money toward the next smallest debt. Continue until after you've paid off all of your debts.
If you respond well to small victories and don't have the patience to tackle large debts first, the debt snowball method is a good strategy.
If you have a small debt, such as a few hundred dollars, you may be able to pay it off in a matter of weeks or months. This first victory might be just what you need to stay on track and pay off the rest of your debt.
Both emotional and financial stress cause debt
It's not always about interest rates or tax breaks when deciding which debt to pay off first. Instead, it could be solely determined by how you feel about the debt.
If you borrow money from a friend or family member, for example, you may feel compelled to pay it off first, even if there is no interest attached. If you have outstanding medical debt, it may take precedence over other types of debt in your mind.
Payday loans, which require repayment by the next payday and often have exorbitant interest rates and fees, may be affecting your emotional well-being. In that case, make every effort to pay off your debts as soon as possible.
Most Commonly Asked Questions (FAQs)
Which debt should I pay off first if one has simple interest and the other has compound interest?
Because compound interest is calculated more frequently, the faster you pay off your debt, the less interest you'll pay. Debt with compound interest is usually a better priority than debt with simple interest.
What happened to my credit score after I paid off my debt?
Paying off debt should improve your credit score if all other factors are equal. If your credit score drops after you pay off debt, it's most likely because negative activity on your credit report outweighed the benefits of debt repayment. For example, if you pay off one credit card but fail to make a payment on another, paying off the first credit card may not help your credit score. Remember that paying off debt is not the same as closing an account; closing an account lowers your total credit line, which raises your credit utilization ratio, which lowers your credit score.
