Sometimes the hardest part about debt is figuring out which loans to pay off first. The best way to deal with this issue is to learn and follow a few simple rules. These rules help you prioritize your debt based on a few different factors.
To start, make a list of all of your loans in a spreadsheet. List the amount and interest rate of each loan.
The first factor you want to consider when paying off your loan is the interest rate. Obviously, the higher interest rate loans should be paid off first. However, don’t just look at the nominal interest rate. You’ll need to look at the after tax interest rate for each loan.
For example, you may have a car loan at 4.5% and a mortgage at 5%. It may look like the mortgage is a higher interest rate, but if you take the tax effect into account it looks different. Because mortgage interest is tax deductible, the 5% rate is really closer to 3.5% after taxes, assuming you pay combined state and federal taxes of 30%. Therefore, it makes sense to pay off the car loan before the mortgage.
Make similar calculations on your spreadsheet to see which loans have the highest after tax interest rate. These are typically the loans you’ll want to pay first.
However, there are a few other considerations that you’ll want to look at.
For example, you’ll want to look at the type of debt. Typically, you’ll want to get rid of unsecured debt that looks bad on your credit report. For example, if you have credit card debt and a car loan that are at the same after tax interest rate, you should probably pay off your credit card debt first. Of course, credit cards are almost always higher than other sources of debt, so they are usually already at the top of your list.
Another consideration is the amount of debt you have. If one of your goals of paying off your debt is to minimize your monthly debt obligations, you might want to work toward paying off one of your lower balance accounts. For example, if you have two credit cards that are the same interest rate but one has a smaller balance, then you could make minimum payments to the larger account and pay the rest toward the smaller balance. That way, when you pay off one account your minimum debt obligations will be smaller. Also, this can give you a little added peace of mind.
A final thing to look at when making this type of debt decision is to think about whether you want to pay off your debts early. If your interest rate is low and the loan is tax advantaged, you should probably not pay off the loan. Instead, you should invest it for retirement or put it in your savings. Especially if you can earn more money on the investment than what you would be saving by paying off the loan.
What Others are Saying About Paying Off Debt
We looked around the web and decided to include a debt payoff method used by many people. It is referred to as the debt snowball method, and according to Wikipedia, it works like this:
The basic steps in the debt snowball method are as follows:
- List all debts in ascending order from smallest balance to largest.
- This is the method’s most distinctive feature, in that the order is determined by amount owed, not the rate of interest charged. However, if two debts are very close in amount owed, then the debt with the higher interest rate would be moved above in the list.
- Commit to pay the minimum payment on every debt.
- Determine how much extra can be applied towards the smallest debt.
- Pay the minimum payment plus the extra amount towards that smallest debt until it is paid off.
- Note that some lenders (mortgage lenders, car companies) will apply extra amounts towards the next payment; in order for the method to work the lenders need to be contacted and told that extra payments are to go directly toward principal reduction. Credit cards usually apply the whole payment during the current cycle.
- Once a debt is paid in full, add the old minimum payment (plus any extra amount available) from the first debt to the minimum payment on the second smallest debt, and apply the new sum to repaying the second smallest debt.
- Repeat until all debts are paid in full.
You can find more information about this at Debt snowball method.
Do you have a method that helps you pay off debt? Please leave us a comment.