If you have more than one form of debt, you may be asking yourself which debt should you pay off first?
Don’t worry, you are not alone. Consumer debt is at an all time high in the United States.
The key to remember is that all debt is not created equally. Therefore, you need to know the difference between the types of debt you have in order to know which one to pay off first.
Don’t worry. In this article, we inform you on what you need to know to make an educated decision. Therefore, you can maximize your money and save as much as you can.
Secured vs Unsecured Debt
Secured debt is backed by an asset. Some examples of this would be Mortgages and Auto loans. If something happened and you can’t make payments, the lender can take your asset.
Unsecured debt does not have collateral i.e. they aren’t backed by an asset. Therefore, they usually have higher interest rates.
Some examples of unsecured debt include student loans, credit cards, personal loans and medical bills.
The decision as to which debt to pay off first depends on your goals.
Goal: Saving The Most Money
If you’re wanting to save the most amount of money you’ll want to pay off the unsecured higher interest rate debt, such as credit cards, first. We refer to this as the high interest rate method.
Credit cards are often very high interest rates and it’s easy to dig yourself in a hole being irresponsible. The good thing is if you have high credit card interest rates, you can always look into consolidation to lower the rates. If you needed help doing that, click on this link here to see what rates you could be looking at.
After your credit cards are paid off, personal loans and then student loans would be the next in line to pay off aggressively. In regards to paying off your student loans –Â It will depend on whether you’re doing a pay off or loan forgiveness strategy. If you go the loan forgiveness route, it will probably not make sense to be aggressive and pay those off.
Goal: Reducing Risk To My Financial Plan
There are two ways of looking at this and you must decide which is best for you…
Way #1
Some finance experts say to pay off secured debt first. The reason being if you stop paying unsecured debt, the worst that can happen is a lien on your assets/bank accounts or bankruptcy. Therefore, if you pay off your car or your house first, you don’t have to worry about losing those things.
Way #2
Reality is its hard to pay off mortgages or car loans first because they are often times much larger than unsecured debt. Plus, other financial experts say not to pay them off first because you can sell the asset and still be in a good financial position. Therefore, pay off unsecured debt.
Typically, this is the way I look at it. Therefore, I typically lean towards paying off unsecured debt first.
Revolving Debt vs Installment Debt
Revolving debt is an agreement that will allow you to take out a preset amount of money. With this type of debt, borrowers may spend the money, repay it, and then borrow it again when needed.
Credit cards are the #1 type of revolving debt. Home equity lines of credit (HELOCs) are also revolving debt.
Installment debt gives you a lump sum amount of debt and payments will be made until that loan is completely paid off. Some examples are installment debt would be student loans, auto loans, and mortgage loans.
Revolving debts tend to decrease your a lot more than installment debt. (Note: The effect on your credit score primarily is driven by your utilization ratio). Revolving debt also tends to have a relatively higher interest rate.
Revolving debt has more risk to it. Therefore, it typically makes since to pay off revolving debt first.
Fixed vs Variable Rates
Fixed rate debts have the same interest rate for the entirety of the borrowing period. Variable rates change over time and won’t stay the same.
When choosing which debt to pay off first, the easy answer is variable rate debt. This reduces the uncertainty in your financial plan which therefore reduces your overall risk.
If you want to see more about this decision, check out this article.
Need More Help?
Choosing which debt to pay off first can be complicated.
This quick guide breaks down from a high level the details you need to know in order to make a decision. However…
We’re always here to help. If you have any questions, become a FitBUX member and we’d be happy to build a financial plan with our one-of-a-kind financial planning technology so you can achieve financial freedom as soon as possible.
By David Hughes and reviewed by Joseph Reinke, CFA
