Buckling down and paying off debt is a great financial task to commit to, but it’s not as easy as just sending in a few payments every month.
After all, not all debt is created equal and, for the sake of saving money and reaching debt freedom a little bit faster, it’s best to be strategic about which debt you tackle first.
Which Debt to Payoff First? (Lowest Balance vs High Interest)
The first step to paying off debt is to get a handle on your debt situation.
When you’re buried under mountains of debt, it can be hard to keep a mental tally of every type of debt you have as well as the details of each account.
Compile a list of every single type of debt you have along with the following information:
- Total amount owed
- Interest rate
- Loan term (if applicable)
Understand the difference between “good” and “bad” debt
Debt is debt and, when given the option, should be avoided. But for the sake of this exercise, it’s important to understand the difference between what is considered “bad” debt and what is considered “good” debt.
Mortgages and student loans are usually considered “good” debt because the interest is often tax-deductible and the interest rates are likely lower than other types of debt. In addition, this is the type of debt that will increase your net worth – owning a home is an asset and a college education can increase the amount you earn throughout your lifetime.
Credit cards, on the other hand, are considered “bad” debt because they often carry high-interest rates and fees that keep the consumer in a never-ending debt cycle. Car loans are also considered “bad” debt because cars depreciate quickly, making it easy to owe more than the car is actually worth.
How can you actually use this?
- Determine which categories your debt falls into and look closely at the rates and balances of your debt. “Bad” debt should be addressed first as its less-than-optimal terms and negative pressures only add to your less-than-ideal financial situation.
- Consider: What are the interest rates and balances on each of these accounts?
Organize them in order, from lowest to highest, in terms of both interest rates and balances.
There are two schools of thought in regards to which of these to tackle first.
Avalance Method (Pay Off High-Interest Debt First)
Some say it’s best to aggressively pay down the account with the highest interest rate first because that is accumulating additional charges at the fastest rate and, once gone, would provide the biggest boost to your financial situation.
Snowball Method (Pay Off Lowest Balance First)
Others believe you should get rid of the account with the lowest balance first because that would provide the biggest mental boost in the debt payoff process.
In other words, seeing one account with a zero balance will give you the motivation to keep going.
Decide which makes the most sense to you.
After all, what works for one person might not work for someone else.
What if you can’t afford all of your debt payments?
Being able to afford all of your debt payments but simply wanting to speed up the payoff process is quite different than struggling to simply make all the minimum payments.
If the latter sounds more like your situation, you might need to adjust how you pay down your debt.
The debt you carry is either secured or unsecured.
Secured debt carries with it some type of collateral.
For example, your mortgage and car loan are considered secured debt because if you default on your payments, the lender can essentially take away your house or your car.
Therefore, if you are in a rocky financial situation, it’s best to ensure you stay current on your secured debt payments.
Before your financial situation takes a tumble downwards, consider speaking with a debt specialist who will help you create a viable plan for your debt and help you return to a solid financial footing.