which debt to pay off first

Debt Reduction Strategy: Which Debt To Pay Off First

Americans now have the most debt in U.S history As of June 2017, Americans owed more than $1.021 trillion.

Unfortunately, just 30% of Americans have worked out a long-term plan for their finances that includes investments and savings. If you’re in debt, it can be difficult to know just where to start when you’re trying to get your finances under control.

If you’re wondering which debt to pay off first and how to take control of your money this year, keep reading to find out where to start and what to do.

Ready? Let’s get started.

Why Pay off Your Debt?

If you’ve been living with debt for a long time, it may simply feel like part of life. Especially if you’re surrounded by friends and family members who are also in debt. Unfortunately, debt can have a massive impact on your quality of life. When you’re not sure which debt to pay off first, it’s easy to bury your head in the sand.

Debt can quickly spiral. If you’ve ever applied for a new credit card because you’ve reached your limit on your current cards, you’ll know how easy it is to dig a financial hole. Unfortunately, this can lead to problems making your payments on time.

Your Credit Score

And if you fail to make your payments on time, your credit score will suffer. When your credit score falls, lenders are less likely to allow you to use credit in the future. Landlords also see your credit score as an indication of whether you’ll be a good tenant and if you’ll pay your rent on time.

If you have a low credit score, you’re unlikely to qualify for that perfect apartment. You also won’t have much negotiating power when you’re negotiating terms.

And when it’s time to purchase a home, the better your credit score, the lower interest rate you’ll get on your mortgage. This could mean you have massive savings over the term of the loan and could afford a larger, nicer home.

Taking Ownership of Your Finances

Convinced that now’s the time to start paying off your debt? While it can be difficult to know which debt to pay off first, this is just the tip of the iceberg when it comes to taking back control of your finances.

The first thing you need to do is make a budget. To do this, you’ll need to complete the following steps:

Understand Your Debt

The first step is to understand what type of debt you have. Money that you’ve borrowed for an education or home is known as “good debt.” This is because these things help boost your financial position later on in life. Some student loan and home debt is also tax-deductible.

You don’t need to worry about repaying these loans as quickly, as long as you’re able to continue making regular payments when they’re due.

“Bad debt” includes any debt that isn’t improving your financial position in any way, and can’t be paid off in full within a couple of months. From a splurge at Sephora to a fancy meal, to a nice vacation, this debt is usually in the form of a personal bank loan or credit card debt.

Look at Your Lifestyle

This can be confronting, but it’s important to think about why you ended up in debt. No one wakes up with debt, and you may be in debt because of the following reasons:

  • A medical emergency and insufficient health insurance
  • A job loss
  • Family responsibilities
  • Poor financial education
  • Bad spending habits
  • A car accident

Unfortunately, it doesn’t take much for most of us to accrue debt. The average American is just one paycheck away from poverty, and a credit card may be the only thing allowing them to pay for that sudden car repair bill or emergency room visit.

For this reason, it’s a good idea to get a notebook or app and keep a running list of everything you spend for two weeks. You may be surprised at just where your money is going, and this will show you exactly where your money is going.

Begin Making Cuts

Before you decide which debt to pay off first, here are some easy cuts you can make to help pay off debt:

Prioritise Your Services

Signed up for Hulu, Netflix, and HBO? It’s time to choose one. Check which service you watch the most and cut out the rest. You’ll save between $7 and $15 for every service you cut.

Exercise Outside

Paying high fees for a health center you never use? Sell your gym membership and commit to exercising outside to save $40-$100 a month.

Pack Your Lunch

Buying lunch at work? Grabbing a latte at Starbucks on the way? Eating out adds up. Take the time to meal prep in the weekend and you’ll not only have more money in your bank account, but your waistline will thank you as well.

Which Debt to Pay off First?

Once you’ve made a budget and you’ve committed to paying off your debt, you’ll need to figure out which debt to pay off first.

The average American owes $26,530 in auto loans and $15,355 in credit card debt. And those who have student loans owe an average of $47,712.

With so much debt, it can be difficult to understand how to prioritize your payments.

There’s no “wrong” way when it comes to paying off debt, but there are a few different strategies which can help you build momentum and improve your credit score along the way:

Start With Credit Cards

When you’re deciding which debt to pay off first, it’s generally best to start with your credit cards. This is because your credit cards are likely to be the most expensive debts you’ll carry, with the highest interest rates. And when you carry large balances on your cards, your credit score is negatively impacted.

Credit scoring models like VantageScore and FICO look at your debt-to-limit ratios. This looks at how much of your credit you’re using at any one time. Your credit score is strongly influenced by your debt-to-limit ratio.

For this reason, when you begin paying off your credit cards, you’re lowering your utilization ratios. And that means you’ll usually see your credit scores climb. You’ll also start saving big bucks on the amount you’re paying in interest.

Pay Off the Smallest Balances

If you have more than one credit card, you’re probably still wondering which debt to pay off first.

It makes a lot of sense to begin working up from the bottom. Make a list of all of the credit cards that are holding debt, and put them in order from the smallest outstanding balance to the largest.

When you pay off the smallest outstanding balance first, you’ll be accomplishing three things: First, you’re reducing the number of accounts you have with balances. Second, you’re reducing your utilization ration to 0% on one account.

Your credit score will usually reflect this action. And third, you’re building up momentum. It simply feels good to have one less credit card weighing you down, and you can use those feelings to motivate you for the next one, and the next.

Go With the Biggest “Boost”

Can you overlook the feelings of momentum and motivation you’ll get from paying off the smaller cards first? If so, you may want to consider which will give you the biggest boost. Financially, it makes the most sense to pay off the debt with the highest interest rate first.

If you pay off $500 on a credit card with an interest rate of 18%, you’ll save much more than if you pay $500 off a bill with a 6% interest rate. While small victories can help you stay focused, this method will save you more money.

Consolidate

When you’ve got outstanding balances on numerous credit cards, it can be a long, challenging process when it’s time to pay them off. It’s difficult to make progress on your debt when it’s all split between different accounts.

When you’re trying to figure out which debt to pay off first, it’s worth considering a consolidation method:

Credit Card Consolidation

If you can get a credit card with a large credit limit and a low interest rate, you can transfer your other credit card balances onto that card. Even if you have a low credit limit, you can also transfer a few of the balances with the highest interest rates.

Home Equity Credit

Another option is a home equity line of credit. This means you’re borrowing against the amount of equity you have in your home. These will usually have higher borrowing limits and lower interest rates than other loans.

But you’re securing them with your home which means you need to be certain you can pay them off.

Debt Consolidation Loan

The final consolidation option is a debt consolidation loan. These are used to combine all of your debts into one payment. It’s important to make sure your loan doesn’t come with any extra fees.

Your bank or credit union will usually have better terms than a consolidation company.

Wrapping up

As you can see, there are numerous options when you’re figuring out which debt to pay off first. The most important thing is that you start somewhere.

Debt doesn’t have to ruin your life. And with the above strategies, you can take back control when it comes to your finances.

Looking for more advice? We have plenty of blog posts about managing your finances so check them out today.