One of the biggest questions that most consumers have when they finally decide to pay down their debts and start living debt-free (or as close to it as possible) is simply this; which debt should be paid off first?
It’s an interesting and important question, to be sure. For consumers who only have 1 or 2 debts, say a credit card and automobile loan, the plan would be rather simplistic. The fact is however that the average consumer has a wide variety of debts, including credit card, automobile loans, student loans, mortgages and more.
If that’s the case for you, the first thing you need to do in order to start paying down your debt is to make a list of all of the debts that you owe in order to determine which of them should be paid off first. Once you’ve got that accomplished, it’s time to categorize your debts.
2 types of debt
There are basically two types of debt, secured and unsecured. A secured debt is tied to an asset, like your home or your automobile and, if you don’t pay back the loan, the lender has the right to take back whatever the asset happens to be. In most cases secured loans have lower interest rates because, if the bills don’t get paid, the lender has something valuable that they can take back.
If you’re in a debt situation where you have, for example, an automobile loan as well as high credit card debt, and paying both is impossible, the automobile loan (your secured debt) should be paid off first because if it’s not, your car will be repossessed. Without a car, getting to work will be much more difficult and the income you need to pay off the rest of your bills will be in jeopardy.
On the other hand, if paying your bills isn’t the problem and you just want to pay down your debt as quickly as possible, paying your credit cards first (your unsecured debt) makes more sense because unsecured debt usually comes with much higher interest rates and, in many cases, is the type of debt that can get out of hand more easily and cost you a lot more money.
Prioritizing based on Interest Rates
If you’re having difficulty deciding which debt pay down first, another system to use that’s quite simple is to look at the interest rate on the debt that you have and pay down the highest first. In fact, you should put as much as possible every month towards paying off the highest debt while making the minimum payments on your other debts and, once the highest is paid off, start again with the next highest debt until all of your debts are paid down.
If you’re having trouble paying your debts your strategy will be slightly different. For example, although student loans are unsecured, the consequences of defaulting on student loans is a bit more severe than with credit card debt, so paying off your student loans first would be advisable.
No matter what you decide to do, making a plan and sticking to it is the only way that you’ll be able to pay down your debt and have a chance of living debt-free. The fact is that it won’t be easy and, if you find yourself in serious debt, the lifestyle that got you there will need to be changed drastically.
That being said, it’s definitely worth doing as, with little or no debt, you’ll have much more extra money to put aside into an emergency fund, retirement account and other investments.