Which Debts Should You Pay Off First?
- There are two common ways to pay off debt -- the snowball and avalanche.
- With the snowball, you start with the smallest balance and work your way up.
- With the avalanche, you start with the highest interest rate and work your way down.
If you feel like you’re drowning in debt and have no idea which debt to pay off first, you’re not alone. In the last few months of 2019, the average U.S. adult owed more than $4,000 in credit card debt, according to the Federal Reserve. And this number doesn’t even take into account other sources of debt like auto, home and student loans.
That’s probably why 37% of Americans say their main goal of 2020 is to get out of debt. The question is: how?
There are different schools of thought on how to approach debt repayment and each have benefits and drawbacks. The process could feel overwhelming, but if you commit to mindful, deliberate, and incremental habits with your finances, becoming debt-free is more than possible. Start by figuring out which debt to pay off first, which framework you should use to do it, and what other options you have.
How much debt do you really owe?
Before you can make a decision about which debt to pay off first, you need three vital pieces of data: balance owed, minimum required payment, and interest rate or annual percentage rate (APR). In most cases, you’ll find those details printed on your monthly statement.
Once you know this information, you can determine the amount you need to pay off each month and in total. A Credit Card Payment Calculator can help you compute this total. Just enter the balance, APR, and minimum payment requirement. For instance, if your balance is $7,000 with an annual interest rate of 12% and a $25 minimum payment due (3% of the balance), the amount you owe is $210 for the month.
Do this for each debt that you have. Once you know how much you owe total and each month, you can consider a number of pay-off strategies.
Evaluate the two most common payment methods
After you answered the question “which debt should I pay off first?”, the next question to answer is “how will I pay it off?” You can choose your answer from two main strategies: the “debt avalanche” and the “debt snowball.” Both of them can be effective, but you need to choose the one that feels most realistic. Here’s a breakdown of each method.
The debt avalanche prioritizes the debts with the highest interest rate first in order to curb the amount of interest you owe. With this method, you continue with all minimum payments each month, but allocate any extra money each month to whichever loan has the highest interest. Keep in mind, however, that since the debt avalanche focuses on minimizing the interest payments, it can take longer to reduce your actual balance with this approach.
With the debt snowball, you’ll prioritize debts with the smallest remaining balance first and pay the amount off in full. As with the avalanche, the snowball requires that minimum payments still be made on all your debt, but extra money then goes toward the smallest balance to more quickly eliminate it.
Since this method can produce real results at a faster pace, it’s an ideal way to gain confidence and keep you motivated.
Consider Debt Consolidation
If you have a few (or many) credit card balances or loans and can’t decide which debt to pay off first, consolidating all of the debts into one payment is an option. While many people are drawn to debt consolidation, there are some details to consider before choosing this route.
Two common forms of debt consolidation are balance transfer cards and home equity loans, and below is an explanation of both, including advantages and potential risk factors.
This is a credit card that absorbs the debt from multiple lines of credit and places it on a single card with a low introductory interest rate. However, you need to know that lenders often charge 3% to 5%, which—based on the size of your debt—can escalate rapidly.
For example, if the debt is $2,000, your transfer fee could be $60 to $100, which may be feasible to pay off and worth the lower interest. If the debt is $10,000, you’ll be charged a $300 to $500 fee which might not be a smart financial move.
Home Equity Loan
This is a way to consolidate high-interest loans, such as a house payment, using the equity accumulated in your home. In other words, if your current mortgage has a balance of $50,000, but the house itself is valued at $200,000, then you have built an equity of $150,000 which can be withdrawn as a home equity loan.
The loan is then used to pay off debt with a low interest rate and manageable payments. While this approach can be efficient, be aware that there is also a risk of losing your home if you miss payments.
Which debt should you pay off first?
There are many ways to put your debt first this year and get it paid off once and for all. If you’re not sure which debt you should pay off first, use these ideas to get a handle on what you owe and make a dent in your payoff plan!