In What Order Should You Pay Off Your Debts?

In What Order Should You Pay Off Your Debts?

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Let’s face it, we live in a society that encourages you to take on debt. In the US, applying for a student loan has become a rite of passage for American students, while for many taking on a car loan or mortgage is the only way many of will ever own an automobile or home.

Then there is revolving credit—lines for those with respectable credit scores and unsecured personal loans for individuals seeking lending alternatives. And, of course, credit card debt is the only other sure thing in life besides death and taxes.

 


A lot of people cite paying down their debt as their top financial goal; however, they aren’t quite sure of the best way to do it or where to get started. There really isn’t any one “best way” that works perfectly for everyone. Regardless, one thing you have to be clear about before setting out on this path is a solid plan on how you will go about settling your debts without losing the enthusiasm in the long run. 

Join the financial sages at MoneyWizard as they equip you with helpful insights on how best you can proceed to sort out your debts. There are dozens of proven debt repayment strategies, some that we shall discuss today.

Should You Pay Off the Highest Interest Debt First? 

The strategy that best suits you is primarily dependent on your debt and income situation—technically referred to as your debt-to-income (DTI) ratio. This ratio helps you understand how much you are indebted. It also highlights your debts relative to your income. You should always strive to settle your monthly minimum balance and dedicate the surplus to paying off the debt with the highest interest rates.

What are the Debt Repayment Strategies?

The most common debt repayment strategies are the debt snowball and the debt avalanche methods. The debt snowball method involves making your minimum monthly payment and using the surplus to pay off the debt with the smallest dollar value. On the other hand, the debt avalanche method involves settling the debt with the highest interest rates first. Both strategies have their merits, and choosing either plan is subjective.

Should You Pay Off The Smallest Balance First?

Looking at the total amount you owe can be discouraging especially if that figure is significant. It makes you realize the relative difference between your income and the cost of servicing your debt—and how little progress you are making month to month. Well, this notion could not be further from the truth. What you need in reality is the momentum to get started, and the rest will sort itself out.

The debt snowball method encourages you to look at your accounts individually and start tackling the smallest debts while working your way up through the larger ones. This will give you momentum and the satisfaction that you are actually making concrete progress towards becoming debt-free. By knocking off smaller debts, you’ll free more money that will go towards paying off the next smallest debt. The problem with this plan, however, is that you will continue to be exposed to higher interest rate costs (since the debt with the highest interest might not always be the smallest debt). It is very motivating, however.   

Decide on a Strategy: Choose Which Debt to Pay Off First

After fully understanding your debt situation and your personal habits, you can then decide on the best strategy to go with. What is keeping you from getting started yet you have an income? Is it that the total amount you owe looks invincible on paper? Well, if this is the case then paying off your debts from the smallest value would be the best strategy. It will help you get moving, which is exactly what you need—momentum!

However, if your goal is to save on interest costs, in the long run, paying your debts from the smallest value might not be such a brilliant idea. Mathematically, the longer you take to pay off the debts with the highest interest rates the more costly that debt will be. In this case, it is best that you list your debts from the ones with the highest interest rates to the ones with the smallest. 

Now, settle your monthly minimum balance and dedicate the surplus to paying off the debt with the highest interest rate. Continue this approach upon clearing the first debt until you are debt-free. This method makes a lot of sense mathematically. You can also combine the two approaches; using the snowball method to get started, and switching to the avalanche method to save on interest costs. 

Consider Debt Consolidation Options to Save

Another intriguing debt repayment strategy is debt consolidation. This entails taking out one big loan with favorable terms in order to offset your smaller loans in one go. Smart debt consolidation should involve negotiating for a favorable term structure, lower monthly payment, and lower interest rate among other terms. This would help make this new debt obligation less burdening than the ones before. 

Going forward, you will only be dealing with one lender instead of multiple creditors every month. This will help you save time and logistical expenses. Debt consolidation works best for unsecured loans—loans not tied up to securities or assets like student loans, credit card debts, and other personal loans. By paying off smaller debts using the bigger loan, you’ll be saving on interest cost as well as the finance cost owed by the smaller loans.

Loan consolidation does not erase the original debt burden but only transfers it to a different lender under new conditions. Obviously, the new lender’s conditions should be better than the terms of the smaller loans. Before consolidating your debts into one larger debt, it is important to pay attention to the payment schedule in order to avoid paying higher interest rates. In the long run, longer repayment schedules means paying more in terms of interest costs thus defeating the whole goal of saving through consolidation.. 

Conclusion

As mentioned earlier, choosing the best debt repayment strategy is subjective. While someone else’s plan might perfectly marry into their situation, it may not necessarily be the best strategy for you. Regardless, the important thing is to get started!

The only thing worse than wallowing in debt is backsliding. It is important to continually re-examine your spending habits while paying off your debt and after you are debt-free so as to mitigate debt in the future!


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