Which Loan Should You Pay Off First? A Guide to Tackling Your Debt
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There’s nothing more satisfying than paying off a loan and closing a debt chapter of your life. At the same time, sometimes paying off debt requires a strategic approach, which can make it difficult for you to determine in what order you should tackle your debts.
With that in mind, here’s what I know about debt-reduction strategies and choosing which loan to pay off first.
Start by determining which debts are good and which ones are bad
Owing money is never a good thing. But in the world of credit scores and money lending, some debts are better than others. Specifically, mortgages, business, and student loans are thought of as good debts because they’re investments in yourself or an asset.
While good debts obviously have to be paid off, they shouldn’t be given priority. Put your good debts on the back burner and focus instead on your bad debts. However, continue making minimum payments on your good debts.
Bad debt pretty much constitutes everything else, including personal loans, credit card debt, car loans, and pay-advance loans. This isn’t the type of debt you’ll ever be rewarded for having, which is why you should tackle it first.
To get started with your debt repayment plan, make a spreadsheet that includes:
- The amount of each debt
- The type of debt (such as car loan)
- Individual interest rates
- The credit limit (if applicable)
- The term
There are multiple approaches to debt repayment
There are four main approaches to debt repayment. I’ll discuss three in more detail, but the other I will just mention in passing because it’s not an effective strategy.
Debt-repayment strategies can be divided into two main categories: Dividing your payments equally across all your debts, or focusing on a single debt at a time while paying the minimum on all your others.
According to research by the Harvard Business Review, the tactic of applying equal payments to all debts is less effective. In fact, people who tried the various methods found that focusing most of your efforts on one debt at a time helps pay off debts 15 percent faster.
The other category, however, comprises three separate approaches: Paying down debts based on the balance, based on the interest rate, or based on the available credit. There are benefits and drawbacks to each method, but I’ll go over each one.
The important thing to remember is that if you want to pay down your loans as quickly as possible, then the key is chipping away larger chunks of one debt while continuing to make the minimum payments on all your other debts.
Option one: Pay debts in order of the balance size
This is what’s called the snowball method. With this method of debt repayment, the debts you repay get bigger as you gain momentum.
The principle behind the snowball method is simple: You start with the debt that has the smallest balance, focus on repaying it, and then move on to the second smallest debt when you’ve repaid the smaller one.
Say you have four debts that you need to repay. For the largest three, you continue making the minimum payments. But for the smallest debt, each month you pay off as much of the debt as your budget will allow.
The major benefit of this method is the high reward that comes right away. For many people, tackling debt can often seem like a thankless endeavor that never bears fruit. But when you’re able to knock out an entire debt soon after starting, you’ll be motivated to keep going.
The key with this method is to make sure that when you pay off each debt, you continue applying the same amount of money to the remaining loans.
Option two: Pay down debts based on the interest rate
This is the avalanche method, and instead of tackling debt based on the size of the balance, you pay off loans in order of the interest rate.
The first debt you’ll knock off will be the one with the highest rate.
As before, you’ll focus on one debt at a time, making minimum payments to all the others and paying as much as you can each month toward the high-interest loan. Your priority is getting out of debt, but if saving money is a secondary priority, then this is the best option for you.
So why wouldn’t everybody just opt for this method, you ask? Well, although it may save you more money, it may not provide the motivation you need to keep going. Especially if your high-interest debt has a large balance, it could take years before you see results.
It might be good for me to say that you can always use a combined approach. Say you’re money-conscious but also reward-motivated. You can pay off a couple of your lower-balance debts first to get the snowball rolling. Then switch to paying down your high-interest loans.
Option three: Strategize a little more if there’s a big purchase in your future
There is another way that you can approach debt reduction if you’re planning on buying a car, house, or another large-ticket item soon. This method prioritizes a healthy credit score because you’ll be looking to get approved for another loan soon.
This approach involves paying down every credit card so that you’re only using 30 percent of your available credit. Focus on the cards that are maxed or nearing their limit, because these will have the biggest impact on your credit score.
Paying off a loan is always satisfying, so no matter which method you choose, you’re sure to find the reward you’re looking for. When it comes to devising a strategy, you can opt to pay off your loans based on the balance size, interest rate, or the available balance.
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