What Debts Should I Pay Off First?
If keeping up with the bills life has thrown at you is getting more and more difficult to manage, it’s time to get a handle on your debt. But tackling them in the wrong order could lead to serious penalties if you pay off an urgent debt later rather than sooner.
You have questions: Catch up on missed credit card payments or address that pile of student loans? What about those mounting medical debts since you got into that car accident?
We have answers from debt-management experts to help you understand the significance of debt and which should be prioritized to be paid off first. But first, you need to understand the difference between good debt and bad debt.
The difference between good debt and bad debt
All debt isn’t equal. Knowing the difference between which debts are OK to keep around for a bit and those you should work to eliminate ASAP, is crucial to prioritizing your debt payoff plan.
“‘Good’ debts include anything that helps you earn money,” said Melinda Opperman, executive vice president of nonprofit credit counseling agency Credit.org.
That includes things such as a mortgage on a property that helps you build equity, or a student loan if you used it to earn a degree, which in turn gave you access to a higher paying job.
“Even a modest car loan is good if it gives you the means to reliably get to work every day,” said Opperman. “‘Bad’ debts are just dead-weight loss — you’ve already reaped the benefits, and are just paying off what you owe.”
A classic example of bad debt is revolving credit card debt, where you’re getting charged a high-interest rate on spending decisions made months ago but didn’t have room for in your cash budget, like that weekend getaway.
Generally speaking, eliminating your “bad” debts should take priority, while you should focus on keeping up with “good” debt payments.
You can get a better understanding of good debts compared with bad debts here.
Now let’s prioritize those debts!
Prioritizing your debts
First, pay necessities: Housing, food, and transportation
You’ve got to keep producing income to get out of debt, so any expenses that contribute to your staying gainfully employed is a budget priority.
As Opperman put it: “If your car gets repossessed and you can’t get to work, you won’t be able to pay off anything else. So those essential bills have to be paid first to keep you working and able to earn.”
Life essentials like savings, rent or mortgage, groceries, phone service, child care, car expenses and whatever else you need to get to work need to be the first line items on your budget.
Savings are a top priority
“Pay yourself first” is a popular phrase in personal finance that means you should save first. Why? Well, because …
“When an emergency happens, the only option you have is debt if you don’t save money,” said Randy Williams, CEO of Cincinnati-based nonprofit credit counseling agency A Debt Coach.
The first thing you should do when you get paid each period is to transfer some of your paychecks to savings, even if it’s something as little as $5. Over time, it will add up, as long as you keep contributing.
Legal obligations are necessities
Legal obligations like child support, alimony, court and criminal fines, most taxes and most student loan payments get lumped up there with necessities because falling behind on those can mean harsh consequences like wage garnishment or jail time. You also can’t get rid of these debts in bankruptcy. Of the legal obligations, child support is the most important to keep up with, according to Williams.
“It becomes a top priority to me just like a mortgage,” he said. “There’s no way out of that obligation except jail. They have to deal with it as a natural monthly expense debt.”
If you are not able to keep up with child support payments, you may want to consider working with an attorney to go back to court and negotiate it.
If you owe the IRS in back taxes, you can negotiate a payment plan with them.
“The IRS is always willing to set up a payment plan with somebody,” said Williams. “If you owe the IRS and you are sending them money, they are happy. They know that you’re trying everything you can.”
All federal student loans offer deferment, forbearance and income-based repayment plans that can work with your budget. If you’re at risk of falling behind on your student loan payments, contact your loan servicer to ask about your repayment options.
“I think people should treat [income-driven repayment] plans as a temporary fix,” said Martin Lynch, an education director with Cambridge Credit Counseling in Agawam, Mass. He said the option can be used if you need a brief relief from the monthly payment to find new employment or reduce expenses, and then go back to making the regular payments.
“If it takes you a year or two to take care of those obligations and rein those in, income-driven repayment can be a lifesaver,” said Lynch.
Once enrolled in an IDR plan, you must recertify your income and family size with your loan servicer to remain on an income-based repayment plan, and that may increase or decrease your monthly payment. If you don’t recertify, you’ll be placed back on a payment plan that pays the loan off in 10 years.
If you’re having a hard time paying for your necessities, you may qualify to have your federal student loans placed into deferment or forbearance. When loans are deferred or in forbearance, you won’t be required to make any payments, but interest may continue to accrue on your loans, so you may see your balances go up over time.
Then, everything else
Everything else comes afterward — including non-legal obligations like credit card debt. Lynch said not to let debt collectors call you and scare you into thinking otherwise.
“The collectors will put your priorities out of shape. They don’t care what your budget is.” said Lynch.
If your debts are taking up too much of your income
If you’re at the point where you’re using your credit card to make ends meet each month, you’re not alone — 42% of Americans are plugging holes in the ship you’re on, too, according to a study by CompareCards.com, which is owned by LendingTree. But the last thing you want to do is pay for your groceries with a credit card because you don’t have enough money left over to buy groceries after making all of your minimum payments.
If making debt payments on time leaves little room for the necessities in your budget, Williams said you might want to consider getting professional help from a credit counseling service.
Decide which debts will provide the biggest benefit once paid off
Now that you’ve set aside funds for the most urgent and important expenses in your budget, it’s time to tackle your “bad” debt.
Debt avalanche vs. debt snowball
How you decide to pay off your unsecured debts will depend on your personality and how you want to judge your success. There are two common DIY methods to tackling unsecured debt: the debt avalanche and debt snowball.
If your goal is to save the most money in interest payments, you’ll probably want to try the debt avalanche method. With the avalanche, you sort and pay off your debts starting with the debt that charges the highest APR and ending with the debt that charges the lowest interest rate.
If, however, you need a mental boost when paying off your debts, you may opt for the snowball method instead. The debt snowball method sorts your debt payoff from lowest balance to highest balance.
“It would lose you a little money but some people need that confidence boost that comes from seeing a debt go from in collections to paid in full,” said Todd Ossenfort, the chief operating officer of Pioneer Credit Counseling, a nonprofit credit counseling agency based in Rapid City, S.D.
The snowball method doesn’t save as much money as the debt avalanche because you may not pay higher-interest debts off before lower-interest debts, but it can be more mentally rewarding for some.
Will paying off debt affect my credit score?
“The largest impact in your credit score will come from your unsecured debt and your [credit utilization],” Williams told LendingTree.
Your credit utilization ratio — the amount of your total credit limit you’re using — determines 30% of your FICO credit score. Williams recommended you reduce your credit utilization to less than 30%.
As you pay down debt and lower your credit utilization ratio, you should begin to see your credit score rise in time.
Additional ways to pay off debt after it’s prioritized
If you have a number of unsecured debts that are difficult to manage, you may want to consider consolidating unsecured debts with a personal loan or balance transfer credit card to reduce the amount of interest you currently pay on them or reduce the number of payments you have to make each month. There are risks to consider with each debt consolidation option, mainly racking up debt on your credit cards after the balances are paid off with the loan or balance transfer.
Debt management plan
If you’re having trouble getting out of debt on your own because your interest rates are too high or you have too many bills to juggle, you may be able to qualify for a debt management plan with a nonprofit credit counseling firm.
When you’re enrolled in a debt management plan, a credit counselor will work with you and your creditors to agree on a monthly payment plan that ultimately reduces your monthly payment and interest rates on your debt. After that part is done, you’ll make monthly deposits with the credit counseling organization, then they use your deposit to pay your creditors according to the payment schedule. Debt management plans generally take three to five years to pay off your debt.
Credit counseling firms generally offer some light credit and debt counseling for free, but some firms charge a fee to enroll into a debt management plan, so be sure to ask ahead of time about any fees you’d pay. Unlike debt consolidation with a personal loan or balance transfer, a debt management plan requires you to close all of your credit card accounts, which may negatively impact your credit score.
The case for budgeting
“If you’re overwhelmed there’s a really good chance that you’re not budgeting,” said Williams of A Debt Coach.
Budgeting begins with listing all of your financial responsibilities. Make a list of all of your fixed expenses and debt payments. With debt, be sure to note the interest rate you pay on the debt.
If seeing all of your debt laid out discourages you, try to remember you didn’t rack up all of that debt overnight, so it’ll take time to pay it down, too, said Ossenfort.
Set up your budget to address debt payments one month at a time. Figure out how much money you have left over after your savings and fixed expenses each month to contribute toward your debts, and stick to the monthly numbers to keep yourself from getting overwhelmed.
“Once they see the budget, they see that they have money at the end of the month, they generally feel more confident in their ability to cover their expenses,” said Ossenfort. “In this case, slow and steady wins the race. It takes dedication and putting your nose to the grindstone to get out of it.”
Follow through with a budget
Make a plan and actually follow through with it.
“A crucial thing is to ensure the budget actually works. Sometimes numbers on a spreadsheet don’t work in real life. So we start by tracking spending,” said Opperman. She suggested tracking your spending to get a complete picture of your budget and making adjustments over time.
“That means flexibility is important. Not only creating and living with a budget, but making changes to that budget based on your experience,” added Opperman.
And if you’re having a difficult time, get some help.
“Everything we do is habit building. If you’re into the habit of [budgeting] then you’re going to do great. If you’re not and you’re starting new, contact a credit counselor and check out the budgeting programs that they have,” said Williams.
Apps are a good option for those who struggle to make a budget. View our list of top budgeting apps for Android and Apple devices here.
Paying down multiple debts can be a long process, but it’s possible if you prioritize and stay focused.
“The biggest thing is you know is it’s really not as overwhelming as people think and that there’s always light at the end of the tunnel. It can always be fixed,” said Ossenfort.
Lynch suggested building small, reasonable rewards into your debt paydown strategy so that you don’t feel starved in the process, as that can lead to spending binges or convince you to ditch your budget.
“For people who are working with a professional counselor, or even with a spouse, don’t let somebody be judgmental about your priorities,” said Lynch. “You are going to resent that imposition on your priorities. Being judgmental is the last thing a counselor should do and a person that wants to do it themselves shouldn’t do that either.”
Ultimately getting out of debt should be something that you want to do. When you really want something, there’s nothing that anyone can say or do that will stop you from your goal.