Which Debt Do I Pay Off First?
We go into step 2 of our 10 steps to financial freedom. We give an overview of paying off high interest debt.
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Step Two is to Pay Off High Interest Debt
High interest debt is debt with an interest rate over 10%.
Most likely this is credit cards, but could also be retail financing, pay day loans, or auto loans. Any debt you have over 10% is what we will focus on.
Typically lower interest debt would be mortgages or student loans. While they are lower interest, there may also be other tax advantages for not paying off these lower interest debts. Lower interest debt will be taken care of at a different step.
Paying off your highest interest debt first saves you the most money.
This is called the Avalanche Method. You list out all your debts from highest interest rate to lowest interest rate. You can exclude debts under 10%. Now you begin to pay off the highest interest rate with your surplus, while still making minimum payments on all other debts. Once you finish paying off a debt, you go back to your list and pay the next highest rate. Your surplus would be bigger now since you have less debt payments.
A quick note on “Surplus”
Monthly Surplus = Monthly Income - Monthly Expenses. The surplus is the money you have left over after paying expenses. In step one, you used your surplus to save one month of living expenses. Now in step two, your surplus is used to pay off your high interest debt.
Paying off your lowest balance first gets your first debt paid faster, but will cost you more money and time.
This is called the Snowball Method. You list out all your debts from lowest balance to highest balance. You can exclude debts under 10%. Now you begin to pay off the lowest balance first, while making minimum payments on all other debts. Once you finish paying off a debt, you go back to your list and pay the next lowest balance. Your surplus would be bigger now since you have less debt payments.
So which debt should I pay off first?
The avalanche method (paying highest interest rate first) is what we recommend. You will spend less money and pay off your debts faster.
The snowball method can be beneficial if you need a mental win faster. In this method, you are likely to get one of your debts paid off faster, but your total debt will be higher and you will have to be paying this debt longer than the other method.
Picking between methods is less of a concern if the interest rates are similar and the balances are small. On the other end, if there is a significant difference in rates and balances, this could cost you thousands of dollars and additional years in debt.
There are a few things you can do to reduce your debt load.
Explore if a balance transfer is available to you. You may be able to transfer debt balance to another credit card. Transferring a high interest debt to a lower rate will save you money over time.
Reduce the amount of credit cards you have. It can be overwhelming to have many credit cards. Find what is manageable for you. You may not be able to cancel immediately due to an outstanding balance, but reducing your burden in managing all the cards will alleviate some of your financial burden.
You can typically update the payment date on your debts. Scheduling everything at the end of the month can allow you to get a better idea of your financial picture when you review your accounts and budget at the beginning of the month.
Once you have paid off debts, you will want to avoid going back into high interest debt. You have your one month living expenses saved up as a buffer. Credit cards can be there in a time of need, but debt shouldn’t be used to fuel a lifestyle you can’t afford.
Sometimes you will need to go back to step one.
If your one month living expenses is reduced below your target, you will need to pause on step two and go back to step one. This will be a constant in the ten steps. Your financial situation will always be fluctuating and cause you to make updates and changes.