Which Debt Do You Pay Down First?

Not all debts are created equal. So many often ask which debt to pay down first. Though the elimination of debt is a goal many of us share, most consumers have multiple outstanding accounts, and navigating the murky waters of repayment can be difficult without proper planning. If you are wondering which debt to pay down first, you’re in good company, but don’t fear – there are several nuances that dictate which debts deserve your attention above others. Below we explain the differences between debts, and how to decide which ones to repay first.

Avoid Neglecting Retirement Savings

Before we get into which debt to pay down first, it is equally important to continue saving for retirement. This is especially true of 401k plans that your employer matches. MSN Money points out that by not contributing to your 401k you could actually lose thousands of dollars in free money from your employer every year. “If you make $40,000 but don’t contribute that 6%, you’re missing out on $1,200 of free employer money,” they explain. “Worse, that money and your missing contribution can’t grow tax-deferred over the next 30 years. If they could, and they earned an average 8% annual return… that one year’s contributions could have grown to more than $35,000.”

Consider Annual Fees

Some banks charge an annual fee for maintaining an open credit line. Annual fees can get hefty, and CreditorWeb reports that they sometimes climb over $100.00. If you are paying $30.00/month, this means that a single fee can completely negate more than three months worth of payments.

Let annual fees serve as an incentive to get the debt paid before the year’s end. Check with your bank for any indication of an annual fee on your accounts, and prioritize paying off any line with a heavy fee.

Be Aware Of Rate Changes

As you are deciding which debts to pay off first, make sure you consult your paperwork and be on the lookout for impending rate changes. Some credit cards jack up your interest rate after a set time period, making it important to eliminate the debt before it begins costing you more money.

Other times, your rate will increase due to other activity in your financial life. MSN Money indicates that your rate can change based on your credit score, available credit, spending habits, and more. Take the time to call your credit card support line and determine if you are at risk for a rate increase, as this information will help you decide which card to attack first.

Pay Attention To Tax Deductions

Carefully review your interest rates to see if any of them qualify as tax deductions. For these debts, it may be better to just pay the minimum every month and use the interest to reduce your annual taxes.

Mortgages and student loans fall into this category Since these are typically the biggest debts that most people owe, it is generally more practical to aggressively pay off credit cards and smaller loans that don’t carry tax benefits (and probably come with high interest rates) before attacking them.

Prioritizing Debts By Level Of Importance

Which Debt to Pay Down FirstSometimes debt prioritization is more about practicality than sheer mathematics. Debts that have a significant impact on your daily life should always be take precedent over consumer debt. As an example, if you are a homeowner, your mortgage is the most important debt you have because you need to keep a roof over your head.

Another example of this is child support and alimony. Not paying these debts could mean jail time, so they cannot be delayed in the name of dispelling credit card debt. They key with this approach is to identify areas of debt that directly contribute to your well-being and ensure that they are paid before making anything more than the minimum payment on everything else.

Pay Off High Interest Debt First

All else equal, attack your debt with the highest interest rate first (i.e. the Debt Avalanche). BankRate.com advocates this strategy, instructing the consumer to pay down debt in order of interest rate. “The best way to get rid of debt, experts agree, is to attack the balance with the highest annual percentage rate first,” they advise. “When that one is paid off, move onto the debt with the next-highest interest rate.”

Typically, these are your unsecured credit cards that carry interest rates that sometimes soar above 25%. With interest rates so high, minimum payments will almost never eliminate your principle and could have you paying forever, or at least certainly longer than it makes sense to. This approach advocates ignoring the actual amount of money owed on each debt, because huge interest rates generally cost you more per month than smaller ones.

Establish An Emergency Fund

Financial experts advise that every person, regardless of their finances and what debts they owe, should establish an emergency fund with several months worth of living expenses. The number of months you ought to save for varies depending on who you talk to, but the logic here is sound. AskMen.com advises this strategy as a cornerstone of every responsible financial plan. “It pays to have a plan in place no matter how [the economy] plays out, and the first item on your financial agenda should be setting up an emergency fund for any and all unforeseen turbulence,” they explain.

AskMen is correct in this regard – though you should remain optimistic about the future, accept the fact that lay-offs, sudden illness, car trouble, and other serious financial stressors are a part of life. Prepare for these unfortunate events by going over your expenses and determining how much money you need to stay afloat for several months. As you pay down your debts, be sure to put money into your emergency account until you reach this amount.

Colin Schipper is a freelance writer for FundingUniverse. Funding Universe matches qualified entrepreneurs to banks, investors and other funding sources. Funding Universe helps small businesses avoid scams and rip offs by securing funding from trusted national banks and financial institutions

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Last Edited: December 8, 2011 @ 11:48 pm

Comments

  1. Mike Dunham says:

    Having recently just started a Dave Ramsey-style “debt snowball” (i.e., pay off the smallest balance first, then the next smallest, and so on, regardless of the interest rate), I ran the numbers both ways. We have a credit card, a car loan, an unsecured loan relating to a business purchase, two school loans, and a mortgage. Mathematically speaking, paying them off according to the highest interest rate gets me to zero two months earlier and saves me about $7700, so it would seem to make sense.

    But, I’ll be sticking with the snowball. Although the first three would be paid off at roughly the same time (right around three years from now), and the sixth would be paid off at about the same time (9-1/2 years from now), the snowball has us retiring the fourth debt in under five years and the fifth debt in 6-1/2 years, compared to eight years and 9-1/2 years, respectively, under the highest-rate-first method. This basically means I’m paying $7700 extra for the psychological reward of getting to a couple of intermediate steps significantly faster. Not exactly chump change, but spread out over a decade, well worth it in my opinion.

  2. Good analysis, Mike. I agree that it can definitely make sense to go with the snowball method if that resonates with you best. Hey, whatever works, right? Good luck in your efforts, Mike. Thanks again for sharing.

  3. It’s also good to keep in mind the secured debts. You want to make sure you stay current on any debt that secures something that affects your way of life (house, car, etc.)

  4. Thank you for publishing this article to my weekly compilation.

    Hope to see another one soon.

    http://ditchtheboss.blogspot.com/2010/11/your-financial-independence-compilation.html

  5. As someone who dug out of quite a bit of debt in my younger years, I’m a big proponent of the debt snowball method (ie… paying off the smallest balance first and re-applying the freed up cash to other bills, and so on). Freeing up that extra cash every month really made me feel like the noose was loosening and it allowed me to better handle financial “emergencies” without resorting to using the card again.

    That said if there is a ridiculous gap between interest rates you kind of have to pay off the highest interest rate % first, but if the rates are close I would go debt snowball first.