Which debt should you pay off first?

Dealing with debt can be hard. It’s not just a matter of how much money you owe, but also all the different types of debt you might have. Organizing your debt payment priorities can address both parts of the problem.

It’s not uncommon for an American household to have credit card balances, a personal loan, a mortgage, an auto loan and some student loan debt. Each of those loan types has its own characteristics in terms of how expensive they are, how flexible the payment terms are, and what’s at risk if you fall behind.

Those characteristics should impact which debt you try to pay off first. Getting your debt payment priorities right can not only keep those payments organized but also reduce how much money it costs to pay off your debt.

Unfortunately, a recent study shows that Americans often get their priorities wrong when it comes to paying off debt. A look at what people are doing wrong can shed light on the right way to approach debt payments.

Many Americans don’t have their debt payment priorities straight

A recent report by credit scoring firm FICO highlighted how Americans prioritize their debt payments, based on how often they fall behind on different types of debt.

The report found that too often, people manage their debt payments in a way that costs them more and puts them at more risk than is necessary. Here are some examples:

• Americans with both auto loans and mortgages are more likely to fall behind on their mortgage payments than their auto payments. That doesn’t make a lot of sense. Both are secured loans, which means you have something to lose if you don’t make your payments. But which would you rather lose: your home or your car?
• People who have both a mortgage and a personal loan are more likely to make payments on the mortgage. This makes sense — but only to a degree. Yes, it’s more important to keep up with required mortgage payments, because your house is at stake. However, once you make the required monthly payments, it may be a better idea to put any extra payments towards the personal loan. That’s because personal loan interest rates are generally higher than mortgage rates.
• Those who have both a personal loan and credit cards are more likely to keep up with the loan payments. That can be a costly choice. Most personal loans are unsecured, as are most credit cards. So the risk in each case is similar. However, average credit card rates are much higher than personal loan rates, so you’ll usually save more if you pay off the credit cards faster.
• People with both credit cards and student loans are more likely to fall behind on their student loan payments. While the high interest rates of credit cards make them a priority to pay off faster, there are often alternatives to falling behind on student loan payments. Federal student loans offer income-driven repayment plans and other types of flexibility to borrowers who are having trouble making their payments.

The behaviors described above are examples of people choosing the wrong payment priorities. This can subject them to higher costs or other types of penalties.

Two common debt payment strategies: Snowball and avalanche

To look at how people can better prioritize their debt payments, a good place to start is with two popular strategies: the snowball method and the avalanche method. Both methods have their supporters, but neither one is a perfect solution for all situations.

• The snowball method involves starting with your smallest debt first. By putting any extra money towards your smallest debt, it will allow you to eliminate one of your outstanding balances in the shortest amount of time. You can then move on to the next smallest debt. Some people gain satisfaction from seeing the number of debts they have start to decline sooner, but this often is not the most cost-effective approach.
• The avalanche method involves directing any extra money towards your most expensive debt first. That would be the debt with the highest interest rate. By paying this debt off first, you get the most bang for your buck in terms of reducing future interest charges. That means more of your future payments will go towards paying down principal instead of interest. This can be a much more cost-effective payment approach than the snowball method.

The big flaw of the snowball method is that it doesn’t take into account differences in the type of debt you have. The avalanche method at least takes interest rates into account. Still, there are other characteristics that different types of debt have. These should be considered when setting your debt payment priorities.

 ➤  LEARN MORE:How to get credit card debt under control

Which type of debt should you prioritize first?

The first rule when setting payment priorities is that whichever strategy you use, it’s vital to make the minimum payments on all your debts on time. Failure to do so can hurt your credit score and cost you in the form of late fees and other penalties. Prioritizing payments involves using any extra money you have available, once those minimum payments are made.

A number of things should factor into how you prioritize any extra payments you make. These include whether the account is up to date or past due, the interest rate and how flexible the payment terms are.

Every situation is different, but in general, here is a logical “batting order” for deciding where to apply any extra payments first:

1. Past due/delinquent accounts

Having overdue accounts on your credit reports is a red flag for lenders and a serious drag on your credit score. It may also subject you to added costs, such as late fees and penalty interest rates. So, getting any delinquent accounts up to date should be your first payment priority.

2. Credit card debt

Credit card debt generally has much higher interest rates than most other forms of consumer debt. So, the longer you carry it, the more it costs you. That’s why paying down credit card debt should be a high payment priority, starting with the card that has the highest interest rate.

 ➤  FREE TOOL:Credit card payoff calculator

3. Personal loans

Personal loans generally have interest rates that are lower than credit card rates, but higher than rates on auto loans or mortgages. That should place them after credit cards as your next payment priority. However, personal loan rates can vary a great deal, so that should factor into where you prioritize them. The higher the rate, the more urgent the priority.

4. Auto loans

Because auto loans are secured debt, they generally have interest rates that are fairly low, but not as low as mortgage rates. That should typically place them between personal loans and mortgage debt in terms of payment priority.

5. Mortgage debt

Mortgage rates are typically lower than most other forms of consumer debt. So, it’s normally more cost-effective to put extra payments towards higher-interest forms of debt first. Having said that, keep in mind that your mortgage is secured by your home. That makes it especially important to keep up with your regular mortgage payments.

6. Student loans

Student loan rates are comparable to mortgage rates, but other characteristics come into play when setting payment priorities. Student loan payments have special programs for borrowers who are having trouble making their payments. So, given their relatively low rates and flexible terms, it’s generally best to pay off other forms of debt before making any extra payments on student loan debt.

 ➤  LEARN MORE:How to pay off debt and use your credit card at the same time

How to build your debt payoff plan: Step-by-step

The above sequence of priorities is just a general list. Your list will depend on your specific debts. Here are some steps to help you determine your debt payoff plan:

1. Make a list of all your debts. Include how much you owe, the minimum monthly payment, the due date for those payments and the interest rate on the debt.
2. Total all the minimum monthly payments you have. That total will tell you the minimum amount of money you’ll need every month to keep up with your debt obligations.
3. Work out a budget to find room for extra payments. This may involve finding ways to cut spending or taking on extra work to allow you to pay down debt faster. Besides your regular budget, stay alert for additional opportunities to pay down debt. These may include lump sum payments like tax refunds or bonuses.
4. Decide on a strategy for prioritizing where those extra payments should go first. Generally, paying off your highest interest debt first is the most cost-effective approach. However, you may want to consider other factors, such as whether the payments are fixed or flexible.
5. Figure out which payments you should automate. Automated payments generally work best if the payments are fixed rather than variable, and if you have enough regular income to cover them.

Other ways to pay off debt faster

Regular payment strategies are designed to help you chip away at debt steadily over time. In addition, other approaches might make your payments more affordable:

1. A debt consolidation loan. If your credit is good enough for you to qualify for a loan, you should consider whether it would be worthwhile to consolidate some of your existing debts. You can do this by taking out a new loan to pay off those debts. This makes the most sense if you can get a lower interest rate on a new loan than you’re paying on the existing debt. Personal loans and home equity loans are common examples of consolidation loans.
2. A balance transfer credit card. Another way to consolidate debt is with a balance transfer credit card. These often offer a zero percent interest rate during an introductory period. If you can budget to pay off debt within that zero percent period, it can save you money on interest charges and allow you to pay off debt faster. Be sure to consider any balance transfer fees that may apply before you choose this strategy.
3. A debt management plan (DMP). This involves working with a nonprofit credit counselor. They may be able to set up a structured payment plan based on negotiated lower rates or a modified payment schedule.
4. Debt settlement. This involves negotiating to pay less than the full amount you owe. This is typically only an option with unsecured debt. There is no guarantee of success, and this approach can have a negative effect on your credit score as well as tax consequences.

The best debt payoff strategy is the one you’ll stick to

Bill payments may come from month to month, but you should take a longer-term approach to paying off your debt. Budgeting for extra debt payments and being strategic about how you apply those payments can help you reduce debt faster and more cheaply.

Most importantly, choose a strategy you can stick to over the long haul. That way, each month can bring you a step closer to being debt-free.

Frequently asked questions

Is it better to pay off debt or save money?

Except for setting aside a little money for emergencies, it’s generally better to pay off debt before trying to save money. Many forms of consumer debt have higher interest rates than the returns you can generally get from investing or saving. Getting rid of your debt payments first will leave you more money to put towards savings in the long run.

Does paying off debt improve your credit score?

Yes, paying off debt can improve your credit score. It depends on what score you’re starting with, but most people have room for improvement. Carrying lower balances is good for credit scores. The biggest impact may come from bringing past-due accounts current.

Should I pay off the smallest debt or the highest interest first?

To get the most out of your payments, pay off the highest interest debt first. This will allow you to bring down the amount you owe faster and more cheaply. Track your progress based on how much money you owe, not on how many different debts you have.

Should I pay off debt before applying for a mortgage?

Yes, if you have a fairly high amount of debt relative to your income. You don’t have to get debt down to zero, but the lower you can get your debt-to-income ratio, the better.

How do I pay off debt on a low income?

When money is tight, budgeting is key. Make sure you cover your minimum payments every month, and try to leave room to make extra debt payments regularly. In the long run, reducing debt will leave you more breathing room in your budget.

What happens if I only pay the minimum on my credit card?

Paying only the minimum on credit cards is not a cost-effective way to pay off debt. It will take you a long time to pay off your balances, and in the meantime, you’ll pay a lot of interest. Besides making all your minimum payments, your goal should be to put some extra money towards your highest-interest debt each month.

 ➤  LEARN MORE:Does carrying a credit card balance hurt your credit score?