Which Debt Should I Pay First?
Shalom Kamau
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Which Debt Should I Pay First?
If you are buried in a mountain of debt, you are not alone. A 2022 report by The Federal Reserve Bank states that debt grew by 7.8% by the end of the year, with revolving and nonrevolving debt increasing by 14.8% and 5.6%, respectively. Most people had mortgages, credit cards, and student loans to pay, with more than 64 million Americans struggling with credit card loans alone.
So, where do you start if you finally want to pay your loans and get your finances in order? Which debt should you pay first?
Some experts say you should repay the debt with the highest interest rate first, while others claim you should begin with the smallest debt. Both approaches can work, but before you jump the gun, you need to determine which is the best method for you.
Here, we cover a 3 step process of determining which debt to pay first, how to handle credit card debt, and how to stay out of debt once free. Let’s dive in.
3 steps to determine which debt to pay first
Step 1: Understand the type of debt you have
Debts are not equal. Understanding the type of debt you have will help you know which one hurts you the most, and that should be what you should start paying as soon as possible. Most loans are either secured or unsecured, and repayment methods are either revolving or in installments.
Installments are most common in secured loans, where you pay a certain amount of money to the bank or lender every month. On the other hand, revolving debt means you have an available balance you can borrow and repay at any time.
Step 2: Track your expenses, budget, and allocate money to pay debts
Do you spend your money as you earn it or rely on a budget? To know how much you can channel towards debt repayment, you must first know how much you spend every month. The easiest way to collect this data is by tracking your expenses.
Tracking your expenses simply means noting how much you have spent on a purchase or bill and tracking it over a week or month. Thus, each time you use money, note it down. It’s a lot easier if you use the numerous online money trackers available today.
A good trick is to note down the expenses immediately after you make a payment. This way, you don’t trouble your mind trying to remember trivial details.
At the end of the month, you will know how much money went into needs such as food and electricity and wants such as eating out and partying.
Once you track your expenses, write down all the debt you owe, their monthly installments, and the repayment period. Using this data, create a budget that includes your monthly expenses, then plan how much you will use to pay the loans.
According to Geroge Samuel Clason, Author of “The Richest Man In Babylon”, every expense you have is you working for someone else. In his book, Clason says the easiest way to get out of debt and build wealth is by paying yourself 10% of your earning without fail, using 70% for living expenses, while 20% goes to paying debts.
With that in mind…
Step 3: Determine Which Debt To Pay First?
So far, you know the type of debt you have and have allocated a budget toward repayment. But which debt should you pay first?
Option 1: The most pressing debt strategy
Chances are, you started this journey because you either want to get out of the debt rat race or there is a pressing debt you need to repay as soon as possible. If the latter is the case, this is the debt to start with.
Pressing debts are loans that are almost due or already in collections. Having debts in collections means you are behind on payments, and your creditor (the institution you owe) has sent your account to a collections agency.
In this case, start by paying off this loan while making minimum payments on other loans.
Option 2: The avalanche debt payment plan
Interests take up a huge chunk of the minimum amount you pay each month. This means the higher the interest rate, the longer it will take to pay off a certain debt. In this case, it’s wise first to pay off debts with the highest interest rate.
Once you are done with one, move to the next highest-interest loan until all debts are paid. While this strategy works, it’s more of a marathon than a sprint. It will take time to see significant changes in your debt balance, which could be discouraging for some people.
In the end, your total interest will be low, which is an advantage.
Option 3: Use the snowball debt payment plan
If you want to see changes soon and be motivated to keep going, this is the plan for you. Experts recommend this plan to people sinking in debt and wanting the mental relief that comes with knowing they are working towards getting out of the dark hole.
With the snowball plan, you ignore the interest rate and start by paying the lowest debt you have first. This means a big chunk of your debt repayment money is spent on paying the smallest loan while still meeting the minimum amount of other loans.
Once you pay off that debt, you increase the premium of the next smallest debt until all debts are paid. That is, the money you used to pay debt A will be added to the minimum amount you pay debt B, and so on. This strategy offers more immediate results, which can serve as great motivation.
Option 4: Loan terms strategy
Most people don’t read the fine print on the loans they take. However, knowing the terms and conditions of your loan is vital when you want to get yourself out of debt. It lets you know what’s at stake if you default. For instance, defaulting on a car loan will wreck your credit score.
Payday loans, short-term personal loans, and auto title loans are notorious for this. Defaulting damages your credit score and increase your debt. For instance, payday loans are rolled over into a new loan (re-borrowing) within a month, increasing your interest.
In such cases, you are better off paying these loans as soon as possible while making minimum payments on all other loans.
Which Credit Card Loan Should You Pay First?
GoBankingRates says that 6% of Americans, or 14 million people, owe more than $10,001 in credit card debt. While these cards can be a lifesaver, accumulating too much debt on them can cripple your finances.
So, which credit card debt should you focus on?
Experts agree you should use the avalanche method when tackling credit card debt. Credit cards usually have high-interest rates (on average, 19% interest), so starting here saves you money. If the debt is too big, use the snowball plan, so you see results sooner and remain motivated to keep paying.
Should You Use Debt Consolidation To Get Out of Debt?
Debt consolidation usually sounds like a good idea, but that’s not always the case. When you consolidate your debt, you opt to pay one large debt with one interest rate instead of many smaller debts with varying interest rates.
Sounds like a dream come true and a lot easier to handle, but again the devil is in the details, so don't forget to look at the terms first.
When you consolidate your debt, you are hoping to get a lower interest rate which doesn’t always happen. In fact, the repayment terms may get pushed back, which forces you to pay the loan longer than you should.
Ideally, instead of paying off the unsecured loans, you have grouped them up with your mortgage (a long-term loan) and will end up paying them longer. Additionally, by using your house as collateral, you ran the risk of facing foreclosure.
That’s not all. If your financial situation worsens, and filing for bankruptcy is the only option left, consolidating your loans can make it difficult to discharge your debt without losing your home.
How To Prioritize Debt When Money Is Tight
Paying your debt when money is tight can be overwhelming, but hang in there. Ideally, start with debts that have the heftiest consequences if you default. This may be your mortgage, taxes, child support, and credit card debts. For instance, when you delay paying your taxes, you accrue interest of 0.5% every month you don’t pay up. This can quickly snowball into large debts if you aren’t careful.
But before all that:
How To Stay Out of Debt
The snowball method is often the best way to get out of debt. Debt comes with mental stress, so seeing yourself conquering it brings a lot of satisfaction and builds momentum to keep going. Eventually, you pull yourself off the hole and live happily ever after.
But how do you ensure you never become a debt prisoner again??
1. Keep 10% of your income for yourself
In his book “The Richest Man in Babylon”, Clason says you should pay yourself 10% of your total income. This 10% should go into your savings.
This is important for two reasons.?
According to Personal Capital Wealth and Wellness Index report in 2022, only 47% of Americans can’t handle a $500 emergency without worrying. Building an emergency fund that can cover 3 to 6 months of your living expenses.
2. Watch how you spend your money
Imagine you just got a pay rise and can finally afford that car, house, or vacation you’ve been dying to have. While nothing is wrong with wanting nice things for yourself, making a big purchase is often the first step to sinking into debt.
More often than not, people tend to upgrade their lives when their money increases, which, according to experts, often leads to overestimating how far the pay increase can go. Thus, you borrow by moving to a bigger house, taking your kids to a better school, and buying a better car. Without realizing it, you increase your debt.
Instead, try and maintain your current lifestyle as much as possible and use the pay increase or extra money you have after all debt is paid up to invest and grow your passive income. Instead of using your money on liabilities, you use it to build assets.
Assets increase your income and will eventually give you the freedom to buy anything you desire without worrying about the price tag.
3. Invest in money-making assets
In the Netflix show “Get Smart With Money,” Teeze Tabor a football sensation, narrates how he went from $1.5M to around $200k before he realized just how fast money could slip through your fingers. When he started working with Ross Mac, a wall street veteran, and financial educator, shows Tabor how and where to invest money.
At the end of the 1.5-hour show, Tabor consistently invested in the S&P 500 and diversified in real estate.?
In 2022, 58% of American adults had invested in stocks , one of the most common ways to invest and grow your money. Other ways to invest money include:
Getting a paycheck at the end of the month means you work for money. But investing make money work for you. You outpace inflation, and you can build wealth and even retire early. Use the power of compounding, re-investing your interest, and eventually, you will be finally free and never at risk of being buried in debt.
What to Do Now?
According to fidelity bank, paying off debts takes at least 68 payments if you owe around $35k. While this may seem like a long time, don’t be tempted to underestimate what you can do in five years and overestimate what you can do in a year. When it comes to money and debt management, a steady pace is the key to making it work. So, make a debt management plan and take action today, regardless of your financial journey. Just start.