The best way to pay off debt isn’t the same for everyone. In fact, the debt you should pay off first depends on your income, expenses, and other obligations, such as being financially responsible for children or aging parents.
Whether you’ve got a mountain of debt or just a few credit card balances you’d like to pay off, how and when you tackle your debt depends on your individual circumstances. Here’s how to determine which debt to pay off first.
- Because every borrower is different, there is no “right” way to pay off debt.
- It may make more sense to pay off secured debt before unsecured debt so you can protect your assets.
- There are several tried-and-true methods for paying off credit card balances according to interest rate and balance size.
- You may want to prioritize paying off debt that's causing you the most stress.
Debt by Type
While all debt boils down to the money you owe, there are a few different types of debt. For instance, installment loans are lump-sum loans that you borrow and then repay in monthly installments over a few months or years. Revolving debt is usually an available balance you can borrow from rather than taking a lump-sum payment. Instead of borrowing once and making payments as with an installment loan, you can borrow at any time.
Installment loans include:
- Mortgages and home equity loans
- Auto loans
- Student loans
- Personal loans
Revolving debt includes:
- Credit cards
- Home equity lines of credit
- Personal lines of credit
There are also two kinds of debt: secured debt and unsecured debt. Secured debt is backed by collateral, while unsecured isn’t. If you fall behind on payments to a secured debt—like a mortgage or car loan—that collateral could be repossessed by your lender.
While unsecured debt doesn’t require collateral, if you make a payment that's more than 30 days late, you could hurt your credit score and your chances of borrowing in the future.
Whether your debt is secured or unsecured is important because it could impact which debt you pay off first. For instance, if you just bought a home—one of the biggest purchases of your life—you probably will not be financially able to pay off your mortgage right away. However, if you recently graduated college and are only making minimum payments on your student loan, you may want to consider making larger payments in order to pay off that debt sooner. Also, it’s wise to pay off secured loans first so you don’t run the risk of losing your collateral.
Debt by Interest Rate
The interest rates you are paying may also determine which debt to pay off first. For example, a credit card with a high APR will take a long time to pay off since interest makes up a big chunk of your minimum payments each month.
If you want to tackle high-interest credit card debt, you could use the “debt avalanche” method. With this strategy, you’ll pay off the loan with the highest interest first while continuing to make minimum payments on your other debt. Once your highest-interest debt is paid in full, put the extra money you used for the paid-off debt toward the card with the second-highest interest rate. Continue this process until all your debt is paid off.
The debt avalanche method is a good strategy for people who want to pay off high-interest debt as soon as possible, even if you won’t see results immediately.
Interest rates are just one factor to consider when deciding which debt to pay off first. It may make more sense to pay off your smallest balances first to build momentum or pay off an overdue balance that might go into collections soon.
Debt by Balances and Terms
While the debt avalanche method might save you more money, you may be better off using the "debt snowball" method. Rather than focusing on interest rates, you pay off your smallest debt first while making minimum payments on your other debt. Once you pay off the smallest debt, use that cash to make larger payments on the next smallest debt. Continue until all your debt is paid off.
The debt snowball method is a good strategy if you respond well to little victories and don’t have the patience to tackle big balances first.
If you have a small debt, like a few hundred dollars, you might be able to pay this off in a few weeks or a couple of months. This first win may be the motivation you need to stay the course and pay off your remaining debt.
Debt by Emotional and Financial Stress
Sometimes the debt you pay off first has nothing to do with interest rates or tax breaks. Instead, it could be solely based on how the debt makes you feel.
For instance, if you borrowed money from a friend or family member, you might feel a strong obligation to pay off that debt first, even if there’s no interest tied to it. If you have outstanding medical debt, that may get your attention over other types of debt.
Payday loans, which require payment by your next payday and tend to charge exorbitant interest rates and fees, might be taking a toll on your emotional health. In that case, try to pay off those loans as soon as possible.
Frequently Asked Questions (FAQs)
When one debt uses simple interest, and the other uses compound interest, which should I pay off first?
Compound interest is calculated more often, so the quicker you can pay off that debt, the fewer interest costs you will incur. Compared to debt with simple interest, debt with compound interest is usually a better priority.
Why did my credit score drop after I paid off debt?
All else equal, paying off debt should increase your credit score. If your score decreases after you paid off debt, it's probably because negative activity elsewhere in your credit report outweighed the benefits of paying off your debt. For example, if you pay off one credit card, but you miss a payment on another credit card, your score may not benefit from paying off that first credit card. Keep in mind that paying off debt is different from closing an account; closing an account reduces your total credit line, which increases your credit utilization ratio, which decreases your credit score.