Deciding which debt to pay off first is an important personal finance question. The type of debt, interest rate, and your financial situation all factor into the best payoff strategy. Prioritizing high interest credit cards and loans can save substantial money compared to focusing on lower rate debts first. Let’s dive into the smartest approaches for common debt types.
Why Debt Prioritization Matters
Repaying debts with the highest interest rates first allows you to reduce expensive finance charges more quickly. This frees up cash flow faster to accelerate paying down lower rate debts. Failing to prioritize can cost thousands of dollars in unnecessary interest expenses over time.
Consider this example:
- Credit card debt: $5,000 at 18% interest
- Personal loan: $8,000 at 10% interest
- Student loans: $15,000 at 5% interest
If you focused on the student loans first because it’s the largest balance, it would take over 2 years to pay off and incur over $1,500 in total interest.
Paying off the credit card first would knock out the highest rate debt in less than 1 year. You’d then have that monthly payment amount plus the savings on high credit card interest to put towards the personal loan. This structured approach minimizes interest costs and time under debt.
So even though student loans or mortgages may represent bigger balances, attacking the most expensive debt produces better financial results. Let’s examine strategies for common debt types.
Best Ways to Pay Off Credit Card Debt
Credit cards typically carry double digit interest rates ranging from 14-24% APR. This makes credit card debt usually the most expensive and highest priority to pay off fast.
For example, a $5,000 balance at 22% APR costs over $100 monthly just in interest. The key steps to effectively eliminate credit card debt include:
- Pay more than the minimum – Minimum payments only cover a small amount of interest and principle. Paying extra directly reduces the principal faster.
- Focus on the highest rate card first – If you have multiple cards, pay minimums on all but the card with the highest rate. Put any extra funds towards that card first until it’s paid off.
- Reduce expenses – Freeing up cash flow by reducing discretionary expenses allows bigger credit card payments.
- Consolidate – Transferring all balances to a new 0% introductory APR card can temporarily halt interest costs while you pay down the debt faster.
- Consider debt management services – Nonprofit credit counseling services can negotiate lower interest rates and facilitate repayment programs. Fees may apply.
As soon as the highest rate card is paid off, roll that payment amount into the next highest rate card, and so on, until all credit card balances reach zero. This “debt avalanche” method saves the most on interest payments.
How to Pay Off Personal Loans Fast
Unsecured personal loans from banks, credit unions, and online lenders offer convenient access to cash and typically have lower rates than credit cards. However, interest rates can still range from 6% to 36% APR.
Follow these personal loan payoff tips:
- Review all rates and focus any extra payments on the loan with the highest interest first.
- Be cautious of extending the loan term to lower payments. This accures more interest over the life of the loan. Opt for the shortest term you can manage.
- Avoid taking out new personal loans to pay off credit card debt unless the rate is substantially lower. The new loan fees and origination costs may outweigh interest savings.
- Consider consolidating multiple personal loans into a lower rate personal loan. This combines balances into one payment at a lower cost.
- Use windfalls like tax refunds or bonuses to make lump sum payments on the loan principal. This cuts down the amount of interest owed over the remaining term.
Paying off personal loans fast saves money on expensive interest and frees up cash flow for other financial goals.
How to Pay Off Your Auto Loan Early
Auto loans make vehicle purchases more affordable by spreading out payments over several years. But the interest still adds up, so paying them off quickly can pay dividends.
Follow these tips to pay off your auto loan early:
- Opt for the shortest loan term you’re comfortable with, even if the payment is higher. Shorter loans mean less interest paid overall.
- Make bi-weekly payments instead of monthly to knock down principal faster. Effectively this makes 13 monthly payments per year.
- Pay a set amount extra each month, like an additional $100. This directly reduces the principal and shortens the loan length.
- Use bonuses, tax refunds or other unexpected cash to make one-time principal reduction payments.
- Refinance if you qualify for a substantially lower interest rate with another lender. Watch out for high fees that could negate savings from the lower rate.
While auto loans are relatively inexpensive debt, paying them off quickly frees up cash flow and reduces the amount of interest paid over the life of the loan.
Should You Pay Off Your Mortgage Early?
Paying off a home mortgage early may seem like a major achievement. But given today’s very low mortgage rates, just making regular payments while investing extra funds often makes more financial sense. The key factors to consider are:
- Interest rate – Current 30-year fixed mortgage rates average under 4%, meaning relatively low interest costs, especially early in the loan.
- Tax benefits – Mortgage interest can be deducted on federal taxes providing savings. Give up these tax reductions paying it off early.
- Investment potential – Extra funds may earn a higher return if invested in retirement accounts than the mortgage interest rate you save paying it down faster.
- Flexibility – Owning your home outright can be freeing but also reduces financial flexibility if a sudden need for cash arises.
Unless your rate is substantially higher than average, making regular mortgage payments and investing extra funds should take priority over accelerating mortgage payoff. An exception could be if eliminating the payment allows focusing more cash flow on paying off much higher rate credit card, personal loan or student loan debt.
Best Ways to Pay Off Student Loans
Education debt can weigh borrowers down for years. Follow these smart strategies to pay off student loans faster:
- Pay extra monthly – Even small additions like $20-50 a month directly reduce the principal balance. This adds up significantly over the loan term.
- Target private loans first – Federal student loans have fixed rates and flexible repayment options. Private loans lack those benefits so it can make sense to pay those more aggressively if you have both.
- Make lump sum payments – Use work bonuses, gifts or a financial windfall to make one-time extra payments and slash the principal.
- Refinance variable rate loans – Private lenders offer student loan refinancing that can roll multiple loans into one new fixed rate loan at a lower interest rate. This can really accelerate payoff speeds. Just be cautious of application and origination fees.
While paying off education debt may require patience and discipline, using these strategies can help you reach the finish line faster while saving money on interest costs.
- Prioritizing high interest rate debts first saves the most money long-term.
- Credit cards and personal loans over 10% interest should be targeted for rapid pay down before lower rate debt.
- Paying more than the minimum due knocks debt balances down faster.
- Consolidating multiple high rate debts via balance transfer cards or loan refinancing can accelerate payoff.
- Use windfalls and freed up monthly payments from paid off debts to funnel into the next priority debt.
- While completely paying off all debt has advantages, maintaining some flexibility is also wise.
With strategic prioritization, steady payments, and smart budgeting, you can efficiently eliminate debt and build financial stability. Stay focused on the end goal of becoming debt-free.
Frequently Asked Questions
Q: Should I use a debt consolidation loan to combine all my debts into one payment?
A: This depends on the interest rate offered compared to your current rates. Consolidating very high credit card rates to a lower fixed loan rate can accelerate payoff. But consolidation loans have fees and may have a higher rate than some current debt. Run the numbers carefully to see if there is a clear savings benefit from the new consolidated loan rate and fees.
Q: Which should I prioritize first – saving for retirement or paying off debt?
A: It generally makes sense to contribute at least enough to a 401k plan to get the full employer match since that equals free money. Beyond that, focusing any extra funds on knocking out debts above around 10% interest before aggressively saving makes sense for most to avoid high interest charges. Once debts are paid down, shift to boosting retirement savings.
Q: Is using my home equity to pay off higher interest debts through a second mortgage or line of credit smart?
A: This allows swapping higher credit card or loan rates for a lower secured rate on your home equity. This can accelerate payoff substantially. However, it also puts your home at risk if the payments aren’t repaid as agreed. Only take this approach if you are confident you can make the new mortgage payments without fail.
Q: I have student loans but also some credit card debt. Which should I focus on first?
A: Generally, credit card debt should take priority over student loans since credit cards almost always have higher interest rates. The average credit card APR is over 16% compared to student loan rates of 5-7%. Pay off the credit cards aggressively first, then shift focus to the student loans. An exception could be if you have private student loans above 10% interest – in that case, consider targeting those right after credit card balances.
Q: How much of my monthly income should go towards debt repayment vs normal living expenses?
A: There is no single right percentage, as it depends on your individual situation. Aim to keep debt payments below about 20% of your take-home pay so you have enough left for essential living costs. If debts are very high, temporarily targeting 10-15% of income towards debt repayment while cutting discretionary costs can help pay them down aggressively. Don’t deprive yourself – find a balance between a reasonable standard of living and making strong progress on debt reduction.
Q: I have a large mortgage. Should I focus on paying that down faster vs other consumer debt like credit cards and auto loans?
A: In most cases, no. With mortgage rates so low currently at 4-5%, you end up better off long-term making minimum mortgage payments and putting extra funds towards higher credit card, personal loan and auto loan rates of 10% or more. The higher rates save you more in interest costs when targeted first. Once consumer debts are paid off, re-direct extra payments towards the mortgage principal. An exception could be if your mortgage rate is also above 10%.