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If you owe money on multiple credit cards or loans, you are not alone. A 2021 Experian report states that the average debt owed by Americans who use credit cards is $5,525. That excludes other debts like mortgages, auto loans, and student loans.
It can be challenging to decide how to prioritize any additional money you have for debt repayment each month, even though you should always pay the minimum amount due on all of your debts each month.
There are several strategies to start paying down debt. But it might be a good idea to prioritize some debts over others. If you just make little monthly payments on all of your debt, you may end up paying more interest over a longer period of time. The most crucial thing you can do to become debt-free is to stick with your chosen debt repayment plan after you’ve made your decision.
Option 1: Pay off the highest-interest debt first
- Principal benefits include the ability to save money and allocate funds to other financial objectives.
- Principal disadvantage: Repaying your largest debt may take some time if it also has the highest interest rate. This could demotivate some individuals, making them more likely to abandon the tactic.
- Best for: Minimizing the amount of interest you pay.
Paying off your debt with the highest interest rate first makes sense because it will save you the most money. APR-heavy credit cards can be particularly difficult to pay off. Anyone who has a mortgage or student loan understands how frustrating it is to make monthly payments that only cover the interest and not the principal.
One popular term for paying off high-interest debt first is the “avalanche method.” Continue paying the minimum amount due each month on all of your credit cards and loans, but allocate all of your extra funds to the loan or credit card with the highest interest rate. If you’re in need of assistance, you can look at these five methods for quickly paying off your debt.
Prioritizing your debt with the highest interest rate is a wise strategy, but it’s not always the best choice for everyone. You might not have much extra money to put toward your debt with the highest interest rate if you’re paying monthly payments on a number of debts. If you have a lot of debt, the avalanche method may also be demoralizing because it may seem impossible to pay it all off. Dollar Coin Example.
Assume you have the following debts:
- Credit card 1: $500 balance and 20 percent APR
- Credit card 2: $1,000 balance and 21 percent APR
- Auto loan: $20,000 balance and 8 percent APR
- Personal loan: $5,000 balance and 12 percent APR
- Student loan: $12,000 balance and 7 percent APR
You’ll make the minimum payments on all your accounts, but apply any extra funds leftover for the month to credit card #2 since it has the highest interest rate. Once it’s paid off, you’ll continue the same pattern by focusing on credit card #1, followed by the personal loan. Continue in this manner until all outstanding debts have been settled.
Option 2: Pay off the smallest debt first
- Principal benefits: Fosters motivation and motivates you to follow through on the plan
- Principal disadvantages: You might have to pay more in interest and it might take longer to get out of debt.
- Ideal for: Those who find it difficult to maintain their motivation to pay off debt
Some people pay off their smallest debt first and work their way up to the largest one, while others decide to handle their debt based on the interest rate. The debt snowball approach to debt repayment, made popular by financial guru Dave Ramsey, is named so because it begins small and gradually increases.
Because paying off a debt in full encourages you to keep working toward your goal, the snowball method works. You’ll have more money to apply to your larger debts as you settle your smaller ones.
Although you may have to pay more interest than you would have if you paid off your highest-interest debt first, the psychological advantages of paying off those smaller debts as soon as possible can be quite satisfying.
List all of your current debts, along with their current balances, arranging them from lowest to highest, to begin your debt snowball. Keep paying the minimum amount due each month to all of your creditors and allocate as much additional funds as you can to the debt that is the smallest. After that debt is settled, use the remaining funds to pay off your next-smallest debt, and so forth. Dollar Coin Example.
Using the same figures above, start by focusing on credit card #1 since it has the lowest balance. After it’s paid off, move on to credit card #2, then the personal loan.
Option 3: Pay debts that most affect your credit score
- Principal benefits: You’ll be in a better position to be eligible for reduced annual percentage rates and higher spending caps.
- Key drawbacks: Paying attention to your credit score might also mean changing your way of life, which makes it simpler to become demotivated.
- Ideal for: Those wishing to finance a major purchase, like a vehicle or home
Lenders can gain insight into your financial management by looking at your credit score. It is influenced by your payment history, the amount of debt you have, and the number of open credit lines you currently use.
Your accounts should be current and your credit utilization, or the ratio of your credit limit to what you’re using on revolving accounts, should be less than 30%. Any lender, including a mortgage loan officer, will reevaluate whether to extend a loan to you if you are in arrears.
Banks and other financial institutions will probably view you as a less risky borrower if your credit score is high. Adjusting your lifestyle to start reducing debt may be necessary if you prioritize your credit score.
It could be very difficult to change your habits, and you might have to prioritize paying off your debt by reducing smaller expenses. Given that a portion of your income will be used to pay off debt, you might become less motivated. Giving up some comforts, though, can help you pay off debt and raise your credit score. Dollar Coin Example.
Assume you have the following credit card and loan balances:
- Credit card #1: $750 ($1,000 credit limit, 75% credit utilization)
- Credit card #2: $1,500 ($3,000 credit limit, 50% credit utilization)
- Credit card #3: $250 ($2,500 credit limit, 10% credit utilization)
- Auto loan: $25,000
- Student loan: $15,500
Pay down credit cards with high utilization rates because they have a big impact on your credit score. Concentrate first on those whose utilization rates exceed thirty percent. You have the best chance of raising your credit score and paying your other bills on time if you use less of these two.
Option 4: Use a balanced method
- Principal benefits: You are able to customize your debt repayment schedule. You could handle the cost in the event of an emergency without compromising your debt-reduction objectives.
- Key drawbacks: Without a clear strategy, you could lose motivation.
- Ideal for: Individuals who can maintain motivation while requiring more flexibility
Taking on your biggest debt might seem like too big of a financial undertaking. Debts that are less urgent, such as those that have been placed in collections, can wait. Debts that qualify for interest-only tax deductions, such as student loans and home equity loans used for the purpose of “buying, building, or substantially improving” a home, may also rank lower on the priority scale.
What actions can you take in these situations? Adopt a stance that is solely your own and balanced. Any of the three debt repayment options can be used, in any order you choose. For example, you could settle an outstanding debt before paying off your credit card debt, and in the interim, just make the minimum payments on your other accounts. Dollar Coin Example.
Using the same figures above, you could start by paying off credit card #3 since it has the smallest balance. Alternatively, you could begin with the debt that has the highest interest rate or monthly payment and work your way down. Alternatively, you could allocate any surplus funds you receive each month to each debt. In the end, you need to create a long-term plan to ensure that you maintain your momentum throughout the payout procedure.
Option 5: Consolidate your debt
- Principal benefits include the potential for a reduced interest rate, easier financial management, and quicker debt repayment.
- Principal disadvantages: There can be upfront expenses, and there’s a chance you won’t be eligible for a reduced interest rate.
- Best for: People making multiple monthly payments with high APRs.
If you wish to combine all of your debt into a single monthly payment, you have a few choices. One option would be to move your current credit card debt onto a balance transfer credit card. The best credit cards for balance transfers provide 15 to 21 months of interest-free transfers, so you have plenty of time to begin paying off your debt without incurring interest on the amount you’ve transferred.
Another option is to get a personal loan and use the proceeds to settle high-interest debt. You can reduce the total cost of your debts if you can locate a personal loan with interest rates that are significantly lower than what you are now paying. Utilize a debt consolidation calculator to determine the potential savings associated with obtaining a personal loan.
Finally, you might want to think about using a home equity loan or home equity line of credit to consolidate your debts. Using a home equity calculator, you can assess if using the equity in your house to settle your debts will result in cost savings. Consider your options carefully before taking out a second mortgage to pay off other unsecured debts because you run the risk of losing your home if you fall behind on your mortgage payments.
There are various debt repayment techniques available, and you can mix and match these tactics to make a plan that sustains your motivation. Just make sure the plan you decide on is doable for you. Put it in writing and promise yourself that you will stick with it through to the end.
Additionally, think about opening a Bankrate account to get personalized product recommendations and analyze your debt. There may be debt products available to assist you in reducing interest expenses as you work to pay off your debt.
FAQ
What loans should you pay first?
By using the debt avalanche method, the debt with the highest interest rate is arranged first among your other debts. You attack the debt with the highest interest rate while making the minimal payments on everything else. You transfer to the debt with the next-highest interest rate after that one is settled.
Which debt should be paid off first?
The highest-interest first plan: Paying off your debts first can help you save money overall by lowering the interest rates on your loans. List your debts in order of interest rate, highest to lowest, if you choose to go with the highest-interest plan.
Is it better to pay off principal or interest first?
Your mortgage’s interest rate will go down if you pay off the principal faster because interest is computed against the principal balance. Even small additional principal payments can help. These are some hypothetical situations with approximated outcomes for further payments.
Read More :
https://www.bankrate.com/personal-finance/debt/which-accounts-pay-first/
https://www.ramseysolutions.com/debt/what-debt-do-i-pay-off-first