Experts: Which Debt Should You Pay Off First?
Consumer debt is a serious problem in the U.S. Nearly two in three consumers are living paycheck to paycheck, including more than half of those with income exceeding $100,000, according to a December 2022 report from Pymnts in collaboration with Lending Club.
Making things worse: most consumer debt comes with interest. “People would be well served to realize that debt extinguishment should be a priority,” advised Robert R. Johnson, PhD, CFA, CAIA, Professor of Finance, Heider College of Business, Creighton University. “To quote Albert Einstein, ‘Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.'”
If you’ve decided to take control of your debt but are unsure of which debt you should tackle first, you’re not alone. Not all debts are equal, meaning there are certain debts you should prioritize paying off as quickly as possible.
To find out which debt you should pay off first and also an effective strategy for eliminating that debt (and others), GOBankingRates turned to financial experts. Here’s what they recommended to help you get your debt under control.
Debt To Eliminate First
Mark Henry, founder and CEO of Alloy Wealth Management, said that high-interest debt, like credit cards, should be the first debt you pay off. “Credit card debt often has the highest interest rates and can really hurt your credit score, making it difficult to get a loan for those other, necessary things like a house or car,” he said.
Payday loans are another form of high-interest debt that you’ll want to pay off ASAP.
Best Strategy To Eliminate Debt
Matthew D. Grishman, principal and wealth adviser at Gebhardt Group Inc., recommends using the snowball method to eliminate your high-interest debts.
“The way the snowball method works is by paying off your debts one by one, from smallest to largest,” Grisham said. “Let’s start by assuming you are making minimum payments to service all of your debt. Step one would be to identify an area where you can reduce your expenses and/or create additional income to pay off your first debt as quickly as possible by making more than minimum payments.”
Grisham said that the income could come from a second job or by eliminating unnecessary expenses from your budget, like dining out or iced latte purchases. He also recommends considering negotiating a lower rate for your cell phone or cable bill or eliminating your cable service until you are debt free.
“Continue making minimum payments on your larger debts while you use this extra income (or expense savings) to eliminate your smallest debt first,” said Grisham.
“Once that first debt is paid off, we move to the next smallest debt, where you take the amount you were paying to eliminate that first debt, use that amount, plus the minimum amount you are currently paying, to start whacking away at debt No. 2.”
He continued, “Once debt No. 2 is paid off, we move onto debt No. 3, where you take the amount you were paying to eliminate debt No. 2 (debt No. 1 payment + debt No. 2 minimum payment) and apply that, plus the minimum payment, to eliminate debt No. 3. This continues until all your debts are paid off. Hence why it is called the snowball method.”
Other Types of Debt You Should Prioritize Paying Off
After you pay off your high-interest debts, such as credit cards and payday loans, here are some other types of debt you should prioritize paying off.
Student Loans
Henry said student loans should also be a priority. “Most people need to take out student loans to pay for an education, and they aren’t inherently bad, but interest climbs quickly and can haunt you for many years to come if you don’t tackle them as soon as possible.”
Jonathan Brown, CEO at JB Brown and founder of Dealflow Broker, suggests focusing on paying off student loans with higher interest rates first. “Explore options for loan forgiveness, refinancing or consolidation to potentially lower rates,” he said.
Mortgage
Brown said that paying off your mortgage can provide financial security and save money on interest. To pay off this debt, he suggests making extra principal payments or refinancing to shorten the loan term.
Car Loans
“Paying off car loans quickly reduces interest payments and frees up funds for savings or investments,” said Brown. He suggests making extra principal payments or refinancing to lower interest rates to help pay off this debt.
Professor Michael Collins, CFA of Endicott College in Beverly, Massachusetts, also noted that auto loans are important to pay off so that you don’t have to make payments that exceed the value of your car.
Personal Loans
“Personal loans should be paid off because they tend to have higher interest rates than other types of debt and can be expensive if not paid off in a timely manner,” Collins said.
Why You Should Avoid Carrying Debts for Years on End
“Carrying debt for years on end can have serious implications on your financial health,” said Collins. “Not only can it be more costly due to the accruing interest, but it can also lead to financial stress and can prevent you from achieving longer-term financial goals, such as saving for retirement. Additionally, it can affect your credit score and can make it more difficult to obtain loans or other types of credit in the future.”
Sean Fox, president of debt solutions with Achieve explained further. “With any debt, you lose the chance to use the money you are paying to the creditor in interest,” Fox said. “On that credit card with an 18% interest rate, paying off the balance means you are saving yourself from losing that 18% — which can be a lot of money.”
Fox also pointed out that the amount of debt you owe is responsible for 30% of FICO scores. “Specifically, the greater your credit utilization — the percentage of your available credit that you are using — the greater the negative impact on credit scores,” he said.
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