How to Prioritize Which Debt to Pay Off First

Date posted: March 3, 2017
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How to Prioritize Which Debt to Pay Off First

Photo Credit: Bruce Aldridge
 

When you start your journey to pay off debt, you might be confused about where to start. Should you pay off your credit card first? What about the car loan? Is your small retail furniture loan the first loan you should tackle or your massive student loan debt?

In many cases, knowing which debt to tackle first isn’t immediately obvious. There are several factors to consider including interest rates, loan principal amounts and your unique psychological makeup. To top it off, there are several different methods of debt repayment, and each of them advocates prioritizing different types of debt to pay off first!

It might sound confusing, but with a little study you’ll be able to determine confidently which debt you should be tackling first. There are several factors that will go into your decision, let’s look at those.

Interest Rate

The first thing you should consider when deciding which loan to pay off first is what the interest rates are on your various debts. If you don’t know your loan’s interest rate, it should be mentioned somewhere on your original loan documents. If you can’t find your loan documents, call your lender and ask.

Credit cards, department store loans (for furniture or appliances) and pay day loans typically carry the highest interest rates. Car loans and lines of credit usually carry medium interest rates and student loans and mortgages typically carry the lowest interest rates, but that can vary depending on your credit score.

Principal Amount

How much you owe is another factor you should take into consideration when prioritizing which debt to pay off first. Along with listing each individual debt and their interest rate, you should list the current balance left owing on the loan. If you aren’t sure what your current balance is (for example, you may not know how much you owe on your car loan), call the lender and ask. While you are on the phone with them, ask them to send you an amortization schedule, which will show how much your loan balance decreases after each scheduled payment.

Small debts with low interest rates should take a backseat to larger debts with high interest rates, since those large debts will cost you much more over the course of their life.

Now that we know the two main factors that you should take into consideration when deciding which debt to pay off first, it’s time to look at a few different methodologies for paying off debt.

Debt Snowball Method

The debt snowball method is a method of debt repayment popularized by Dave Ramsey. It involves listing your debts from smallest amount to lowest amount. Then you tackle the smallest debt first while making the minimum payments on your other debts, and when that is paid off, you roll all of the money you were paying towards that first debt into the second debt, and so on until the snowball is so big that by the time you tackle the last and largest debt, you’ll have lots of money to throw at it.

This method is popular because it takes the psychological aspect of debt repayment into account. It gives you quick wins by paying off your low balance debt first and eliminates your total number of overall debts. This gives you the confidence you need to tackle the bigger debts. The main downside of this debt repayment method is that you may end up paying more interest overall.

Let’s look at this sample of debts below, and figure out which debts we’d pay off first using the debt snowball method.

Debt

Interest Rate

Balance

Credit Card Debt

19.99%

$5,500

Student Loans

5.5%

$25,000

Car Loan

2.9%

$15,000

Now if we were to use the debt snowball method, we’d tackle the debts in the following order:

Debt

Interest Rate

Balance

Credit Card Debt

19.99%

$5,500

Car Loan

2.9%

$15,000

Student Loan

5.5%

$25,000

When we use the debt snowball method we order the interest rates from highest to lowest. That means you would tackle the credit card, then the car loan, then the student loan, even though the car loan has a lower interest rate than the car loan.

Debt Avalanche Method

The other main method of prioritizing which debt to pay off first is the debt avalanche method. In this method, you prioritize your debts by the highest interest first. This method makes the most sense mathematically, because by tackling the highest interest debt first you are automatically minimizing the amount of interest paid.

If we were to use the debts above, this is the order in which we would tackle them.

Debt

Interest Rate

Balance

Credit Card Debt

19.99%

$5,500

Student Loan

5.5%

$25,000

Car Loan

2.9%

$15,000

Using the debt avalanche method, we would tackle the credit card debt first, then the large student loan, and then the car loan. Even though the student loan has a bigger balance, we’ll tackle that first because that will minimize the overall amount of interest you pay.

This method has one major downfall though: it overlooks the human element of debt repayment. Debt repayment is very much a psychological game, and it’s easy to get discouraged and go back to just making your minimum payments. If you attempt to tackle the student loans while still making a car loan, you might get frustrated because it takes so long and give up.

In my case, I had a student loan of $26,500 at 5.5% interest and a car loan of $13,000 at 2.9% interest. Even though I knew it was risky, I still decided to tackle my student loan first because I knew tackling the highest interest loan first would minimize the overall amount of interest I would pay.

My gamble paid off. I stuck it out and paid off my debt altogether in just 24 months.

Whether you decide to choose the debt snowball method or debt avalanche method, just remember that consistency is the key to success with your debt repayment.

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