Paying down debt can be intimidating. Even after you’ve decided to focus on reducing debt, knowing where to start can be tricky.
For consumers, understanding which debts to pay first can mean thousands of dollars in savings. Not all debts are created equal — some can hurt your credit score, and others may have higher interest rates.
Here are some factors to consider when deciding which debts to pay down first.
Know your interest rates
Interest rates vary widely. According to NerdWallet, a personal finance website, the average interest rate for credit card purchases is 18%, while Experian has found that the average interest rate for a new auto loan is only 4.76%. In many cases, the right move would be to focus on paying down credit card debt. However, look carefully at your interest rates to determine which of your accounts is most costly.
If you have high-interest credit card debt, you can save money by transferring your balance. Credit card companies offer balance transfer credit cards that allow you to move high-interest credit card debt to the new credit card with a 0% introductory interest rate. Fees for this transfer typically range from 0% to 3% of the balance. If you plan to take four months or more to pay off a balance, a 3% fee is worth it — you want the transfer fee to cost less than the amount in interest you would have paid on the original credit card.
Protect your credit score
Make minimum payments. While it might be tempting to direct funds only toward highest-interest debt, it’s important to keep paying the minimum due on all accounts. For credit cards, this is typically around 1% of your balance plus interest accrued, while for most loans the amount is a previously agreed-upon installment. Not making your minimum payment to a creditor on time will hurt your credit score for up to seven years — potentially resulting in higher interest rates with less options for other loans, or even employment opportunities, in the future.
Some debts allow modification of minimum payments. In particular, federal student loan payments can be adjusted based on your income, but remember that when your monthly payments go down, the time it takes to pay off the debt and total interest go up.
Mind your credit utilization. Another factor to consider is how paying down debt will affect your credit utilization rate, which in turn impacts your credit score. While paying off any credit card (or revolving account) will lower your utilization rate, you may want to tackle the cards on which you owe over 30% of your credit limit. Owing more than that percentage on an individual account hurts your credit score. Once you have all of your revolving account balances at or below 30% of your limit, you can start to pay off accounts completely.
Protect your sanity
While it makes sense financially to target high-interest debts first, some borrowers find that making their smaller debts a priority can help relieve stress, because doing so reduces the number of accounts and creditors you are accountable to.
Using a debt management tool or calculator can help you track progress and payments.
These factors are just a starting point. Your personal situation will ultimately guide which debt you decide to pay off first. Any way you choose to tackle debt is a step in the right direction.
About the Author:
Courtney Miller is a data analyst at NerdWallet, a personal finance website.
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