If you’re like many people, you’re trying to pay down debt but not sure where to begin. Most of us have several different types of debt, and we aren’t always sure which one we should start with. Those with mathematical brains tend to start paying off debts that have high interest rates first, and that’s not a bad place to start, but there are questions to ask yourself when you’re paying down your balances.
1. Which loan has the highest interest rate?
As I mentioned above, looking at the interest rate of your loans or debts is a good place to start. If you only have a couple different types of debt with dramatically different rates, this may be the only thing you need to look at. Paying off those high-rate loans first can save you hundreds, if not thousands of dollars. For some of us, though, we may have two credit cards with the same interest rate, or we may have a card with the same rate as our HELOC. Then where do you start?
2. What are the consequences if I default?
With some loans, the consequences of not being able to pay are greater than others. These loans, if they are at similar interest rates to other loans, should be paid off first. The consequences of defaulting on a credit card may hurt your credit score, but it probably won’t land you out on the street. Student loans are important to stay current on, though, since they generally aren’t dischargeable in bankruptcy and the government can garnish your paycheck if it deems necessary.
The seriousness of the consequences may also differ from person to person. For example, if you can’t pay off your car, it may get repossessed. While this would be a big problem for someone who drives to work, if you work from home, it may be less serious. Similarly, paying off a student loan may be more important to someone who is considering bankruptcy, since they know that this debt will stick with them.
3. Which loan has the smallest balance?
This criteria is usually less important than interest rate and the consequences of defaulting, but it can help you decide if you have two loans with similar rates and similar default consequences. Generally, loans with smaller balances should be paid off first. This is more for psychological reasons than anything mathematical. When you start getting some of your debts paid off, you start to build up momentum and feel like you are getting somewhere. This can raise your morale and make you want to work harder to get other things paid off. Dave Ramsey’s Debt Snowball method is based off of this concept.
A Final Word
These tips only apply if you already have enough money to cover your minimum payments and are looking to make payments above and beyond the minimum. If you can’t pay the minimum on one loan, there’s not much sense in paying extra on another. It would be better to save your pennies and stay as current as you can on all your bills. The order that you pay the minimum payment is also different from the order that you pay extra, with the essential items coming first.
If you do have enough, though, and want to pay a little extra, these are some rules of thumb that can help you decide where to direct that extra cash. The thing is, no matter what order you pay things off in, it’s great that you’re headed in the right direction. Many of your friends and neighbors are busy digging themselves into debt and you’re digging yourself out of it. So pat yourself on the back, and don’t forget to create an emergency fund so all your hard work isn’t disrupted if you run into hard times. Stay tuned for some emergency fund tips coming soon!