It’s difficult to know which debt to pay off first when you don’t have a firm grasp on your finances. Getting out of debt isn’t something that happens by accident; at least it wasn’t for me. I had to work really hard and put some ingenious strategies into place to succeed.
The good news is that it can be done; if I did it, I know for a fact that you can do it, too. But it takes planning. The first step is knowing which debt to pay off first.
Here’s what I would do (and do on a regular basis).
There’s no way around it; if you are going to get out of debt, you need to get organized. This means finding out what you owe, when it’s due, and at what interest rate. The list should look something like this:
- Amount owed
- The required minimum payment
- The APR (annual percentage rate) or interest rate
- Due date
If, like most of us, most of your debt is credit card debt, then you can find all this information on your credit card statements. If, for some reason, you can’t find that information or you just want to be extra sure, the best approach is to make a list of all your debtors, give them a call, and find out.
That will help you achieve two things:
- Give you an accurate look at your debt landscape (provided your list is accurate)
- Show initiative (some debtors appreciate that and might extend you a courtesy should you ask for an extension or interest rate reduction in the future)
Strategy 1: Pay Off High-Interest Rate Debts First
This is my rule of thumb, and I do believe it is that of many expert debt managers. High interest rates only go towards adding to your debt. Prioritizing credit card debt with the highest interest rates and paying that off first is known as the “debt avalanche” method.
Also see: Debt calculator
It’s a mathematical and systematic approach that is designed to save you the most money in the long run. Here’s the trick:
Paying off debt that has a high interest rate first means that the accrued interest rate on your overall debt decreases.
Here’s how it works: If you take a loan of, say, $100,000 at an interest rate of 7% for a period of about 5 years, your monthly repayment should be somewhere around the $2,000 mark. However, during the front end of the debt repayment, a lot of this $2,000 (about $600) goes towards paying the interest as opposed to bringing the principal down.
In contrast, if you make additional repayments every month, you will pay off this interest faster, meaning that at the end of things, most of your money will go towards paying off the principal and getting you out of the $100,000 debt.
The same thing goes when it comes to credit card debt. That’s one of the main reasons consolidating your credit card debts on a low-interest credit card is a good debt management strategy for savvy girls like you and me.
Strategy 2: Pay Off Small Debts First
This is known as the debt snowball method. Created by a financial expert known as Dave Ramsey, the debt snowball method is where you prioritize paying off the smallest debts first as you work your day to the bigger ones.
The idea behind it is that once you pay off a small debt, you will have freed up a bit more money to take on another slightly bigger debt, and so on and so on.
Dave believes that the method should work for most people because the incentives are inherent; seeing yourself check off debts from your list will not only make you want to keep going until the list is done, but it will also help show you how much money you can have left over once all your debt is gone.
The problem with this method is that it might take you longer to pay off the higher-interest debts because they keep accumulating interest. However, if, like most people (myself included), you find it extremely difficult to stay motivated when it comes to debt repayment, this method might be what you need.
The psychological benefit alone makes this method worth exploring.
Strategy 3: Pay Off Debts that Directly Affect Your Credit Score
Whether or not you plan to live a debt-free life, having a good credit score is always an advantage. It gives you excellent financial options in terms of private loans, should you ever require them. Heck, some employers actually pay attention to your credit score before offering you a job (especially in the financial sector).
If you focus on paying off debt that directly or mostly affects your overall credit score, you will be achieving three things:
- Paying off your debts (which is why you are reading this in the first place)
- Keeping a high credit score
- Giving yourself a chance to get better, cheaper loans
All three things, if managed properly, will keep you from falling back into the cycle of debt from which you are trying to escape and offer you some debt relief.
So, how do you go about this?
Start by looking at your credit utilization. Ideally, it should be around 30%. If you find that any of your credit cards have a higher credit utilization rate (higher than 30% negatively affects your credit score), pay that off first.
Here’s a quick example:
- Credit card 1 has a $1,000 limit, but you have used $800 on it (80% credit utilization)
- Credit card 2 has a $500 limit, but you have only used $100 on it (20% credit utilization)
- Credit card 3 has a $3,000 limit, but you have already used $1,500 (50% credit utilization)
Of these three, credit cards 1 and 3 are really doing a number on your credit score. Those are the ones you should pay off first because their credit utilization is higher than 30%.
Strategy 4: Consider Debt Consolidation
This always works. If at all possible, try as much as you can to put all your credit card debt onto one credit card or a balance transfer credit card. If you find the right one, you could enjoy 0% interest charges on your APR for the first few years (some give you up to two years).
The other option is to take out a personal loan with a bank that offers favorable interest rates. Use this loan to pay off most, if not all, of your debt, leaving you with just one loan to pay off. If you find that the amount offered can’t repay all your debts, focus on paying off the ones with the highest interest rate first. Yes, this is the hill upon which I am willing to die.
These four strategies should help you figure out which debt to pay off first. But most importantly, they should help you stay out of debt in the long run.
If all this seems overwhelming at first, it’s because it really is overwhelming. I have created a Financial Reboot course that should help make it all make sense. You can check it out and get your financial life back on track.