Which debt should you pay off first and why?
These type of questions are popping up in our forum. So, today's article is about "Which debt to pay off first" to help our readers.
Well, the answer is not easy. First of all, you have to understand the type of debt you have incurred.
Not all debts are harmful. You can take your time to pay them off.
In addition to this, when you are deciding to pay off your debts, you have to consider your current financial position, debt load, and motivation.
Here are 6 points which you should consider to confirm “Which debt should you pay off first?”
1 Know your debt type:
To understand which debt to pay off earlier, you should know your debt type first.Types of debt:
This debt is guaranteed by a collateral.
A creditor or lender will offer you a loan guaranteed by the collateral. Example: home loan, auto loan.
This debt isn't backed by an asset or collateral. Example: credit card debt, medical debt, utility bill, and loans or credit without a collateral requirement.
Fixed interest rate debt:
This debt has the same interest rate for the whole loan life. Example: FRM (Fixed Rate Mortgage).
Variable interest rate debt:
This debt has no fixed interest rate. It can change over the life of the loan. Example: credit cards
Tax deductible debt:
This loan should be used for betterment. It gives tax benefits. Example, mortgage loan, student loan.
Knowing the debt type is important to understand what kind of debt you are dealing with. For example, a secured debt like a home loan and a tax deductible debt like a student loan are considered as "good debt".
They are tax-deductible and boost your financial position as well.
You need not hurry in repaying these types of loans as long as you are making monthly installment payments.
Some debts are considered as bad debt like credit card debt, personal bank loan.
These debts are unsecured and don't improve your financial position.
You should repay the debt within the time. Otherwise, you will accumulate more debt in the form of costly interest rate.
2 Figure out which debt is costing you more
It is always wise to get rid of the highest interest rate debt first. If you have multiple credit card debts, you should target the credit card debt with the highest interest rate first.
Try to make the minimum payments on every debts while making a large payment toward the highest interest rate debt every month.
By doing so, you can pay off the highest interest debt soon and can move ahead to the next highest interest bearing debt.
Stick to the method until all your debts are paid off. This method is known as debt avalanche method.
NerdWallet columnist Liz Weston quoted that "With the help of debt avalanche method, you’ll get out of debt more quickly by going after toxic debt first.”
3 Pay attention to your credit score while taking out a loan
"Paying down the debt" scenario comes after the "taking out the loan" scenario.
So, it is important to play a safe game while you are planning to take out a loan. Thus, you will pay off your debt without getting confused.
For example, If you are planning to buy a home or a car, you should check your credit score first.
Because lenders will offer you an interest rate based on your credit score.
If you have good to excellent credit score, chances are high to get better terms and lower interest rate.
If your credit score is bad to average, your loan application may get rejected or the interest rate may be higher.
And a higher interest rate loan means you have to pay more money for a longer time.
So, it is better to build a good credit score before taking out a loan.
4 Be wise
It is true that the high-interest credit card debt can cost you more money and you should pay them as soon as possible.
But, you shouldn't borrow money from your retirement savings (401k) or take out a home equity loan to pay off your "bad debts".
Because, if you borrow from your retirement fund, you can miss the valuable tax benefits.
On the other hand, defaulting on the home equity loan will cause you to lose your home.
Thus, you should find out other options to pay off your "bad debts" first instead of making your financial position more intense.
5 You can start with the lowest balance first
The process of debt repayment can overwhelm you. Thus, to stay focused, you can pay off the lowest balance first. This will help you to build a sense of confidence in you.
You can start with the debt snowball method to pay off the lowest balance first.
In this method, you need to make some extra payment to the lowest balance debt while paying the minimum to the rest.
Once the lowest balance debt is paid off, target the second lowest balance on the list, and so on.
The first win will make you feel good and unburdened.
6 If you are not sure, seek professional help
If you have multiple debts including good debts, bad debts, and worst debts (payday loans), and you are not sure where to start with, then you can seek professional help to get the best advice.
You can consider credit counseling session to get the idea about the best-suited debt repayment strategy.
Lastly, regardless of which plan you consider, it is important to stick to the plan to get success.
Once you decide on a repayment plan,plan your budget according to it .
This allows you to stick to the plan while taking care of your mandatory expenses.
Also, to stay focused toward the goal, reward yourself or share your debt repayment story with your near ones.
Remember, paying off debt is tough, but possible.