What Debt Should I Pay Off First?
If you're in the unfortunate position of trying to decide what debt to pay off first, I know that's stressful.
It's easy to feel as if you'll never have fiscal sanity again. But you can get control of your debt and start chipping away at your balances. The key is to prioritize your debts and pay them off in the most advantageous order.
I'm going to cover both credit cards and certain types of loans. You'll learn the following:
-- Which credit card to pay off first.
-- Other options for debt elimination.
-- Which loan to pay off first.
-- Whether to pay off a debt or save.
[Read: Best Balance Transfer Credit Cards.]
What Credit Card to Pay Off First
There are several strategies you can use to pay off credit card balances. If you plan to tackle debt the old-fashioned way -- one credit card balance at a time -- here are three options to try:
-- Debt avalanche.
-- Debt snowball.
-- Debt blizzard.
Debt avalanche. The debt avalanche approach starts with paying off the card with the highest annual percentage rate first. Next, you pay off the card with the second-highest APR and so on. This strategy saves you the most money because you pay less in interest.
Debt snowball.This approach starts with paying off the card with the lowest balance first, regardless of the APR. Next, you pay off the card with the second-lowest balance and so on. With this strategy, you pay more in interest. So, why would anyone consider this? Advocates say it works for those who need rapid success. You get a quick win because you start with a small balance.
Debt blizzard.This is my own debt-reduction strategy, and it combines the best of both worlds. This approach starts with paying off the card with the smallest balance first to get an adrenaline rush. Next, you switch to avalanche and pay off the card with the highest APR on down to the lowest-APR card. So you get a quick win for a morale boost and then you start saving on interest.
Other Options for Debt Elimination
If you have debt on high-APR credit cards, it's easy to feel that you'll never get out of debt, especially if you're paying it off one balance at a time. Here are two options that might help you avoid -- or at least reduce -- the interest you're paying.
-- Balance transfer credit card.
[Read: Best Debt Consolidation Loans.]
Balance transfer credit card. You'll need a terrific credit score to qualify, but if you can get approved for a balance transfer credit card, this is a great option. You'll get a 0% introductory APR for usually 12 to 21 months. During that time, you pay down your debt while paying no interest. Sounds amazing, doesn't it?
The downside is a possible balance transfer fee, which is usually 3% to 5%. But even if you factor in the fee, you might still save a bundle on interest if you have balances on high-APR credit cards.
Debt consolidation loan.OK, what if your score isn't good enough to qualify for a balance transfer credit card? If you have at least a good score, you could get a debt consolidation loan and still save money on interest. You won't get a 0% introductory APR, but you might get a loan with a lower APR than that on your credit cards.
Which Loan to Pay Off First
There are many different types of loans. There are secured loans and unsecured loans. Credit cards are unsecured loans, meaning that if you don't pay, the issuer can't come to your residence and take your car (or your house, for that matter). You don't put up anything of value, like property, to secure the loan.
So if you're having cash flow issues, it's fine to temporarily pay minimums on your credit cards if you need the cash to meet your obligations for secured loans, like your mortgage or car payment.
Let's take a look at each of these loans, and you'll get a sense of how to prioritize your debts:
-- Payday loans.
-- Personal loans (e.g., home improvement loans).
Payday loans. This is a big one because, according to the Federal Reserve Bank of St. Louis, the average interest rate on a payday loan is 391%.
If you've gotten yourself involved in a cycle of debt, focus on paying this off before it does more damage to your finances. Payday loans are unsecured, but the interest rate alone makes them a priority for payoff strategies.
Some people get in so deep they can't get out. If you need help, there's no shame in that. Contact the National Foundation for Credit Counseling, and ask for assistance.
Installment loans. Credit cards are an example of revolving debt. You have a credit limit, but you decide if and when you use your card. An installment loan has a fixed interest rate, and the number of years you have to pay it off varies. An auto loan is an example of an installment loan.
An auto loan is a secured installment loan because the lender uses the car as collateral. This means if you don't make the payments, the lender can come for your car. So this is a payment you must make. If you can't make the monthly payment, call your lender and work out a payment plan. Don't ignore a secured loan!
>Personal loans. If you have a major expense and you need time to pay for it, a personal loan might work. Rates are reasonable if you have good credit. Personal loans can be secured or unsecured.
Another option is to use your home as collateral and get a home equity loan or a home equity line of credit, or HELOC. A home equity loan comes with a fixed interest rate for a certain period of time. A HELOC is a revolving line of credit, so you decide how much credit you need to use and make monthly payments. But this is a secured loan, so don't do this if you aren't sure you can make the payments.
Here's an insider tip: If you have very good credit and you think you can pay off the loan in 18 months or so, look into getting a credit card with a 0% introductory purchase APR. You'll be able to pay off the balance without paying any interest. It's an unsecured loan, so you won't have to risk losing your house.
[Read: Best Low-Interest Credit Cards.]
Pay Off Debt or Save?
When financial resources are limited, managing your money well is critical. You might be wondering if it's better to save money right now in case you need it.
The right decision is based on two things: your level of job security and the health of your emergency fund. For a look at different scenarios, such as having high-APR credit card debt but with zero savings, check out a recent column I wrote: "Should You Pay Off Credit Card Debt or Save Your Stimulus Check ?" You'll find specific advice for three different situations.
