Debt Prioritization: What Bills to Pay First
- Establishing a debt payoff strategy is key to managing multiple debts and ultimately becoming debt-free.
- Popular debt payoff strategies include the avalanche and snowball methods, which are based on interest rates and the amount of money owed.
- Saving while paying down debt is possible. It can improve financial security and keep you from adding to your debt through continued borrowing.
When you’re juggling multiple debts, it can be hard to know which debts to prioritize first. With that in mind, below is a guide to debt prioritization. We’ll walk you through how to prioritize your debts and get started with a repayment plan from start to finish.
Why is debt prioritization important?
If you feel like you’re struggling to manage multiple debts, it can be a good idea to prioritize them and come up with a dedicated debt payoff strategy. There are a few reasons why doing so will likely be beneficial.
- Ignoring debts can have negative impacts: When you ignore existing debts or default on a loan, those decisions can have negative consequences. In some cases, your credit score may be impacted, making it harder for you to borrow money again in the future. In other cases, the asset you’re using as collateral may be repossessed. And sometimes, a lender can take you to court.
- Carrying debt can be expensive: The vast majority of debt comes with interest charges attached. Expressed as a percentage of the principal loan balance, interest the cost of borrowing that the lender charges you. As a rule of thumb, the longer you carry your debts, the more interest you’ll be charged, so facing your debt head-on can help you save money in the long run.
- Not having a plan can be confusing: When you don’t have a debt repayment plan in place, it can be confusing to know which debts to tackle first, especially if your debts exceed your income and you have to stick to making a few minimum payments. Often, it can feel overwhelming and like you’ll never be able to become debt-free. However, once you prioritize your debts and start working on your plan, it will become much easier to see the light at the end of the tunnel.
Should you build an emergency fund or pay off debt first?
If your income isn’t stable, it’s wise to start saving first so you have a safety net in place. You can still pay down your debts and save, but focus on debts that carry high interest to avoid extra costs and free up more cash sooner.
Here’s how you can do both:
- Build a small emergency fund first. Start by setting a savings goal of $500 to $1,000 for unexpected expenses like car repairs or medical bills. You should also create a system, like automating transfers or setting aside a specific amount of cash every week, that will allow you to easily reach your savings goal.
- Prioritize your high-interest debt. Direct extra funds toward your high-interest credit cards or loans. You’ll make the minimum payment every month, but any additional money you can put toward the balance reduces the interest and principal balance faster.
- Continue contributing to savings while paying down debt. Once the high-interest debt is repaid, you can continue to tackle other debts and save. Add to your savings as much as your budget allows, even if it’s no more than $50 to $100 per month.
How to prioritize debt payments
Now that you know why it’s important to prioritize your debts, the next step is to learn how to arrange them. While there’s no one-size-fits-all answer to debt prioritization, the following guidelines may give you some idea of how to start prioritizing your debt payments.
- Delinquent accounts: If you have delinquent debt, meaning you have missed payments, then you should take care of those accounts first. Like accounts that have gone into collections, delinquent debt can have broader negative impacts than just damaging your credit score.
- Types of debt: Likewise, it’s important to consider whether your loan is secured, meaning it’s backed by collateral. If falling behind on secured loan payments could lead to you losing an important asset – like your home or car – it may make sense to prioritize those payments first, even if the interest rate is lower.
- Interest rate: Next, consider interest rates. Some forms of debt, like personal loans, have fixed interest rates, which makes it easy to budget for repayment. Credit cards, on the other hand, usually have higher interest rates that are variable, which can make it more difficult to chip away at your outstanding balance.
- Principal balance: In some instances, you may want to tackle your debt with the smallest balance first. Paying off a debt early on may help you stay motivated to take on bigger balances later. In other cases, it may make more sense to take on accounts with high credit utilization since this has a larger impact on your credit score.
4 debt payoff strategies to consider
If you’re still unsure of what method you want to follow for prioritizing your debts, here are four common debt payoff strategies that may help.
Debt avalanche method
The debt avalanche method involves paying off your highest-interest debt first. To do this, you’ll make the minimum monthly payment on every card or loan you have, except for the debt with the highest interest rate. Then, you’ll put all of your extra money toward paying down that balance as much as possible.
The theory behind this method is that your debt with the highest interest rate is also the one that is costing you the most money in interest charges. By paying it off first, you’ll be able to put more money back into your pocket and use it to pay off your other debts faster.
While this can be the most cost-effective method, it can also take longer to see results. It’s likely going to be best suited for those borrowers who feel like they can stay motivated if they are saving money in the long run.
Debt snowball method
Meanwhile, the debt snowball method takes the opposite approach from having you pay off high-interest debt. This method recommends that you tackle your smallest debt first while making the minimum payments on the rest of your accounts. Then, after you’ve paid off the smallest balance, you’ll put your extra income toward the next-smallest balance and so on.
The debt snowball method is predicated on the idea that you’ll stay motivated if you create a series of small wins for yourself at the beginning of your debt payoff journey.
While the snowball method makes it easy to see progress right away, you may end up paying more in interest charges over time. This payoff strategy is likely a good fit for those borrowers who may have trouble sticking to a plan where they don’t see immediate results.
Debt by impact on credit score
On the other hand, if you have a significant amount of credit card debt, you may want to organize paying it off by its anticipated impact on your credit score. Put simply, your credit utilization ratio, or the amount of credit you’re using versus the total amount of credit you have available to you, accounts for 30% of your overall FICO score.
Paying down your balances with the highest utilization ratios first will have the biggest impact on your overall credit score. To determine which credit card balances to work on first, look at the amount of credit you’ve used versus that card’s credit limit. The cards with balances closest to the credit limit will likely have the highest utilization ratios.
Listing your debts by credit score impact is most likely a good fit for those borrowers who want to apply for new financing in the near future. Lenders are more likely to approve you for financing if you have a good or excellent credit score. Those with the highest scores are typically given the most affordable rates.
Paying off debt can help your credit score, particularly if you make on-time payments and lower your credit utilization. However, if you were to pay off a loan in full or close a credit card account, your score may decrease temporarily, as this could impact your credit utilization, credit mix and length of credit history.
- Payment history (35% or score)
- Credit utilization (30%)
- Length of credit history (15%)
- New credit (10%)
- Credit mix (10%) (Keeping some accounts open can help)
Debt consolidation
Finally, if you have multiple balances with high annual percentage rates (APRs) and different payment dates, it may make sense to consider debt consolidation. Debt consolidation involves taking out a new loan and rolling all your existing loan balances into it.
This method is common among borrowers who are having trouble managing multiple credit card balances or student loan payments. It can be an efficient way to streamline multiple debt payments into one, ideally at a more affordable interest rate.
Debt consolidation can be a smart solution for borrowers who are having trouble staying on top of multiple payment dates or who feel like they can’t make progress toward paying off debt because each balance is subject to its own high interest rate. However, be aware that getting a new debt consolidation loan may come with an added upfront cost.
Next steps after debt prioritization
After learning about the various debt payoff strategies that exist, you may be wondering how to get started paying down your balances. Here are the next steps you should take.
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Organize your debts: Before you can get started paying down your debts, it’s important to take stock of where you are financially. Create a list of all your existing debts, including:
- Principal balance
- Minimum payment amount
- Payment due date
- Current interest rate
- Decide on a debt payoff strategy: Once you have all that information in front of you, look at the various debt payoff strategies listed above and decide which one will likely work best for your financial goals.
- Create a new budget: After you’ve picked a payoff strategy, it’s time to take another look at your current household budget. Figure out how much money you can allocate toward the first balance you hope to pay off while still covering your bills and all other minimum monthly payments.
- Allocate the money according to your debt repayment plan: Then, each month, distribute the money in your budget according to your debt repayment plan. If you stick to your plan long enough, over time, you will begin to see results. Eventually, you’ll be able to pay off your debt for good.
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