Paying Your Debts in the Wrong Order Could Be Costing You

By Dan Rafter on 16 April 2018 0 comments

If you've resolved to pay off your debt, that's good. But how do you determine which debts to pay off first? The answer can be different for everyone.

There's no doubt that Americans have a lot of debt. The Center for Microeconomic Data found that U.S. household debt reached a new peak in the fourth quarter of 2017, rising to $13.15 trillion. The CMD said that balances rose 1.6 percent on mortgage loans, 3.2 percent on credit cards, and 1.5 percent on student loans during the quarter.

The odds are high that you, too, are dealing with plenty of debts each month. Here are some factors to consider when deciding which ones to attack first.

When to attack unsecured, high-interest debts first

For most people, it makes sense to attack the highest-interest debts first. These are usually unsecured debts such as credit cards and personal loans. With an unsecured debt, there is nothing for the lender to repossess if you don't make payments.

Student loans are another example of an unsecured debt, but they generally don't come with sky-high interest rates. You'll save more money by paying down a $5,000 credit card balance at 18 percent interest than you will a student loan with an interest rate of just 4.5 percent. Debt with higher interest rates grows much faster. If you only make the minimum payments on your credit cards, it could take you years, and loads of interest, to pay them off in full. (See also: All the Ways Minimum Payments Are Evil)

But sometimes you'll hear different advice. Namely, some experts say you should pay off cards with the lowest balances first, even if they don't necessarily have the highest interest rates. The theory is that paying off a debt in full provides an emotional lift that can inspire you to continue attacking your other debts.

This is commonly referred to as the debt snowball method. It isn't the approach that will save you the most money — but it may still be the best choice if it helps you stay motivated and therefore ensures you don't give up before you've paid off all your debts. If you know you need small victories to stay motivated, the debt snowball method may be right for you. (See also: 6 Secrets to Mastering the Debt Snowball)

When to attack secured debts first

Secured debt is tied to some kind of asset. Your auto loan, for instance, is secured by your car. If you don't make the payments on your auto loan, your lender can repossess your car. Your mortgage loan is secured by your home. If you stop making payments on your mortgage, your lender could foreclose on your house.

If you fall behind on your credit card payments, the financial institution behind the card can't seize any of your assets. It can hit you with late payment penalties, of course, and cause your credit score to plummet. Debt collectors can even garnish a portion of your wages if you fall far enough behind in payments and they win a court judgment against you. But that's not as bad as losing the roof over your head or the vehicle you need to get to work.

If you are extremely behind on mortgage or auto loan payments and worried about defaulting, make those payments your priority, even if the interest rates on these loans are much lower than those on your credit cards. It may not be the cheapest method of paying back debts, but it's better than losing the roof over your head. (See also: Why You Need to Know the Difference Between Secured and Unsecured Debts)

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