What Debts Should I Pay Off First?
Paying down your debt is the first step to financial freedom, but where should you start? What debt should you pay first? The answer to that question depends on several things.
Secured versus unsecured debt
There are two major types of debt: secured and unsecured. Understanding the difference is important if you’re borrowing money or prioritizing debt repayment.
Secured debts are secured by an asset, such as a house or car. The asset serves as collateral for the debt. A mortgage and auto loan are both examples of secured debt. Your mortgage loan is secured by your home and an auto loan is secured by your vehicle. If you default on the loan or become delinquent lenders can place a lien on the asset, giving them the right to seize (e.g., repossess or foreclose). The lender can sell the asset to pay the debt, however, if the proceeds from the sale don’t cover the entire debt, the lender may pursue you for the difference, known as the deficiency balance.
Unsecured debts such as credit cards, medical bills or utility bills are not linked to any assets and lenders can’t collect any collateral for the debt. However, lenders can take other actions to get you to pay the debt. For example, they can hire a debt collector and they can sue you and ask the court to garnish your wages, take an asset, or put a lien on your assets until you've paid your debt.They will also report the delinquent payment status to the credit bureaus, which will be reflected on your credit report.
All debt is not created equally.
Are your debts high or low interest (sometimes referred to as good or bad debt)? Certain low interest loans, such as a mortgage, may also provide tax breaks.
Low interest debt is considered good debt because it’s an investment that will grow in value or generate long-term income. A mortgage, automobile loans and school loans fall into this category. For example, a school loan typically has a much lower interest rate than other types of debt and it can increase your future income.
High interest debt such as credit cards, cash advance loans and personal loans for discretionary purchases to acquire things that quickly lose value, are regarded as bad debt. This type of debt generally has much higher interest rates and doesn’t help you generate income.
What is the best way to pay off your debt?
There are a few different debt-reduction strategies but the most popular are called the Snowball and Avalanche methods.
The Snowball Method
This strategy provides almost immediate gratification and motivation by paying off your debt with the lowest balance. You likely won't save as much money in the long term, but this approach may help you stay motivated over the long haul. As you eliminate your low interest debt you can apply the extra cash to the larger accounts. This method should only be used if you feel you'll struggle to stay motivated to pay off your debts otherwise. While the snowball method has it's place, we don't traditionally recommend it for most consumers because they'll spend unneeded money on interest.
The Avalanche Method
This method concentrates on your highest interest debt. The focus is on paying down your most expensive debut until it’s completely paid off, while continuing to make the minimum payment on your other debt. Once your highest interest debt is paid off, you move to the next-highest interest rate debt and allocate any additional debt payments to it. Mathematically speaking, this strategy saves you the most money over time, since you pay the higher-interest debts before lower-interest ones.
You can work with Family Credit Management to find the best approach for you to enjoy financial freedom. Our certified credit counselors will review all your debts and give you a personalized action plan that details the best options for your situation. Get your free quote at here.