Everyone knows that healthy personal finances requires debt reduction. However, paying down debt can become discouraging when you have a great deal of it, from a variety of sources. Paying a little bit extra every month on each of your debts doesn’t seem to make a dent, thanks to high interest charges. Instead, you can make more effective use of your debt repayment funds if you concentrate on retiring one debt at a time. This can also simplify matters and help you focus your efforts. But how do you prioritize your debt?
Photo by Redvers via Flickr
Considerations for Prioritizing Debt Repayment
Most people are familiar with Dave Ramsey’s Debt Snowball. While it is possible to prioritize your debt according to smallest balance, this is not the only consideration. Three other factors to consider when organizing a debt repayment schedule include:
- High interest rates: While it can be emotionally gratifying to pay off your smallest balance first, and give you a reason to celebrate sooner, it may not save you the most money. High interest rates on some debts can mean that you are paying more over the long run. Instead of paying off $500 at 12.99%, you might consider tackling the $800 at 19.99% first. Otherwise, you are spending more money in interest each month, for a longer period of time.
- Variable interest rates: When you have a fixed rate, you know exactly how much of your money is going to pay interest, and how much will actually pay down the principal each month. It adds stability. Variable interest rates, though, can stick it to you on a whim. If your rate goes up, all of a sudden your payments are less effective at reducing debt. Getting rid of variable rate debt ahead of fixed rate debt can help you eliminate a source of frustration and possible inefficiency up front.
- Tax benefits: For those who are interested in consider their home equity loans and first mortgages as part of the debt they want to pay off as quickly as possible, it is important to consider tax benefits. Student loans also fall into this category. You can get a tax deduction for the interest you pay, so tackling these types of debt first may not be completely efficient. Debt is still debt, but at least some of the disadvantages of paying interest are offset by the tax advantages.
Deciding Which Debts to Pay Off First
Gather up all of the information on your debts, and consider the factors above. This can help you make a priority list. If your primary concern is motivation, go ahead and use the Debt Snowball method for your credit card and payday loans first, and then start the process again for your other types of debt.
If you want to save as much money as possible, though, consider prioritizing your debt with a different method. Categorize your debt according to interest rate. Look at your highest rate debts first. Do some of those debts have variable interest rates? Move those to the top of the list. Some of your debts may have variable rates, but be relatively low, like student loans. These types of debt also come with tax advantages. You can move this kind of debt lower on the list.
In the end, you have to determine which debt is likely to be more damaging and costly to you in the long run. (If you are considering your credit score, most of the high interest debt is most damaging, so paying it off first can help you improve how you look on paper.) Here is a sample of an order you might consider for paying of your debts:
- Title loans and payday loans: Usually have the highest interest rates.
- Credit cards: High interest rates that are likely variable.
- Personal loans from financial institutions: Somewhat high interest that may be variable.
- Auto loans: Usually fixed rate, and reasonably low interest rates.
- Unsubsidized student loans: Often have reasonably low interest rates, and could be variable. Might be worth considering switching with auto loans if you have private loans with higher rates.
- Home equity loans and lines of credit: Has a tax benefit, but is often variable with interest rates that are only moderately low.
- Subsidized student loans: Usually have quite low interest rates. If they are consolidated, the rate is often fixed. Plus, you get a tax deduction.
- First mortgage: Low, fixed rate with tax advantage. If your subsidized student loans have a much lower rate, it might be worth it to pay the mortgage off first — unless your mortgage interest deduction is helping to keep you in a lower tax bracket.
Naturally, prioritizing your debt repayment has a lot to do with your individual financial situation, and what you hope to accomplish. But by looking at more than one factor, you will be more likely to prioritize your debt repayment in the way that will benefit you the most (or do the least amount of damage).
Miranda is a professional personal finance journalist. She is a contributor for several personal finance web sites. Her work has been mentioned in and linked to from, USA Today, The Huffington Post, The San Francisco Chronicle, The New York Times, The Wall Street Journal, and other publications. She also has her own personal finance blog: Planting Money Seeds.