Approximately 80 percent of Americans have some debt, and families are taking on more every year. Between student loans, credit cards, auto loans and mortgages, total household debt can add up quickly. If you’re trying to find financial freedom by becoming debt free, you might wonder, “Which debts should I pay off first?”
Should you pay off your lowest balances or highest interest rates first? Can you ignore your mortgage while dealing with credit card debt? There are a few different strategies for tackling debt. We’ll explain the best methods so that you can chip away at your financial obligations.
Good vs. Bad Debt
Before putting money toward your credit, you need to evaluate the types of debt that you owe. Taking out a mortgage or student loan is considered to be constructive because it has the potential to improve your financial standing.
Real estate is generally a good investment. Property usually appreciates in value over time, and you need to live somewhere.
Putting money towards rent payments keeps a roof over your head, but it doesn’t give you an asset that can enhance your financial position. When you own a home, your equity increases as you pay off the mortgage. You can eventually use the equity to take out a loan, get a reverse mortgage or secure some cash when you sell the house.
Student loans are considered to be good debt because furthering your education can increase your earning potential. If you manage your money properly, you should be able to pay off student loans within 10 years.
Credit card debts, vehicle loans and payday or cash advance loans are regarded as bad debt. The interest rates on these debts can be high, and they’re not secured with assets that have a similar value. In other words, if you borrow $33,000 for a car that depreciates to $20,000 as soon as you drive it off the lot, you won’t be able to recoup the money even if you sell the vehicle.
As a general guideline, you should pay off bad debt first. Most experts don’t recommend that you pay off your mortgage early unless it’s the only thing that you owe. You should also consider establishing a 12-month emergency fund and saving at least 20 percent of your income before putting extra money toward a mortgage.
What Will Motivate You to Continue?
It makes more financial sense to pay off high-interest debt before anything else. This will save you the most money in the long run. If you have two credit cards with equal balances, contribute to the one with the higher APR to avoid paying unnecessary finance charges.
What if you have multiple credit cards with different balances? Paying off a $10,000 debt can be more daunting than reducing a $2,000 balance. Regardless of the interest rates, you might be inspired to stick to your debt-resolution budget if you see at least one balance careening toward $0. If that’s the case, you may want to aggressively pay down the lowest balance.
How Will Your Credit Score Be Affected?
If you’ll be trying to secure credit for a mortgage or auto loan in the near future, you should keep an eye on your credit score as you pay off debt. Pay down any credit cards with balances that are approaching the limit first. As you improve your utilization ratio, which indicates the total debt balance divided by the total available credit, your credit score will improve.
Making Debt Payoffs Work for You
The best debts are those that don’t charge interest. As you work on tackling various balances, take action to reduce your interest rates. If you have a good credit score, you should be able to take out credit cards with promotional interest rates that offer no or low APRs. Transfer balances onto these cards so that you don’t accrue additional debt while you work on the balances with higher interest rates. You can also try calling your credit card companies and asking them to reduce interest rates.
When you have several credit cards or loans with varying interest rates, your best bet may be to consolidate them through a debt consolidation company. This may be able to lower the average APR, which will reduce the total that you pay over the years. Plus, keeping track of a single loan is much more convenient than paying attention to multiple payment due dates. Consolidating your credit may prevent you from paying late fees.
Make sure that you continue to pay the minimums on every balance even if you direct the majority of your funds toward one. Late payments may affect your credit score. Furthermore, they’ll add to your debt, which is exactly what you’re trying to avoid.
Which Debts Should I Pay Off First?
The debt reduction method that works best for you depends on the situation and your own attitude.
If you have trouble sticking to your goals, you should put most of your income toward the loan with the lowest balance first. When you bring that balance to $0, move to the next-highest balance.
If you’re trying to maintain or improve your credit score, pay down unsecured loans that are nearing their limit before other balances. If you are dedicated to sticking with your budget and want to minimize your spend, direct the most money toward the loans with the highest interest rates first.
Whatever approach you choose, you can reduce headaches and potentially lower your interest rates by consolidating your debt. Contact Christian Debt Counselors to find out how we can help you save money and time while becoming debt free.