You've Been Warned: Paying Back Debt In The Wrong Order Will Cost You
If you have some of your income left over after paying living expenses, congratulations are in order. Next, you might be wondering what's the best use of those funds? Is it more important to pay off debt or start saving? Alternatives include starting an emergency fund, investing toward your retirement, or getting debt under control. If you opt for the latter, a new set of questions unfolds. Primarily, which type of debt should you pay down first? Student loans? Mortgage? Car payment? What about credit card balances?
Evaluating your total debt can be daunting, but an excellent place to begin is to write down all loan balances, along with the interest rates you're being charged for each. A good rule of thumb is to try to pay down the highest interest rate loans first. This is sometimes known as the "avalanche method" to repaying debt. High-interest rate loans can include credit card balances, payday loans, and rent-to-own schemes for furniture and electronics. For example, many credit cards charge upward of 25% interest on balances. Reducing or eliminating that extremely pricey debt is the equivalent of getting a ~25% return on investment. Plus, the reward is tax-free. Even the scorching stock market at all-time highs of late can't outperform that return.
Two different methods for repaying debt
If you want to pay off your credit card balances more quickly, per the avalanche method, consider doing a balance transfer. Often, credit cards offer low- or no-interest balance transfers to attract new cardholders to apply. These promotional balance-transfer periods can stretch as long as 18 months, though some are shorter. If you're able to transfer your high-interest rate balance to a new credit card with a much lower interest rate, more of your money will go toward paying down the principal instead of paying pricey interest.
Interest rates aside for a moment, some personal finance gurus recommend a different order for repaying debt, as outlined in the "snowball method." The snowball method involves paying off debts with the smallest balance first, regardless of interest rates. Of course, you'll still need to continue making at least the minimum payment on other debts. But paying off the smallest debt first, then moving on to the second smallest debt, and so on, encourages a feeling of accomplishment and self-satisfaction. However, be aware that this approach is designed to be more motivational rather than the most cost-effective. Still, it's better than doing nothing about mounting debt.
Using a combination of strategies
It's also worth mentioning there are certain types of debt that transcend the payback order of either the avalanche method or the snowball method. For example, if an account is delinquent, you'll want to get that loan caught up posthaste to avoid further damage to your credit score, regardless of the interest rate or balance amount. Yet another example of prioritizing would be an auto loan that risks having the vehicle repossessed for non-payment. Ditto if you owe money to the IRS for unpaid taxes. Those are not situations that you'll want to ignore in favor of paying down a credit card in order to save you in the long run.
In reality, an effective debt repayment strategy could incorporate multiple strategies. For instance, you might use the "smallest debt first" strategy to motivate yourself at the beginning and to nurture better financial habits, then decide — wisely — to tackle the highest interest rate loan next.
Finally, you may have to think twice about making extra mortgage payments. Unless your home's mortgage originated within the past year or two, the odds are that the interest rate is very reasonable by historic standards. As well, the interest may be deductible from your federal income taxes if you have chosen to itemize deductions (here's how to know if you should). Unless you're otherwise debt free and already maxing out retirement account contributions, you'll probably want to focus extra cash elsewhere rather than aggressively paying down a home loan.