A reader recently posed the question to me, “What debts should I pay off first”? Here is a breakdown of common debts and how to tackle them.
Credit Card/other unsecured loan Debt: Generally, credit card and other unsecured loan debt carry the highest interest rate charges. Furthermore, credit card issuers show no mercy in jacking up your interest rate after you are even a day late in making your monthly payment. According to IndexCreditCards.com, the average amount of credit card debt for households with credit card balances was $7,394 as of 2010; with rates averaging between 17-20%. With these high rates it makes sense to place a high priority on paying of this type of debt.
Auto/Other Personal Loans: It has become a normal practice for American consumers to perpetually have an auto loan. By the time (or even before) their auto loan is paid off, many consumers choose to finance a new vehicle. Over the long run, perpetual car loans have a huge negative impact on your wallet. Too often, borrowers find themselves being “upside down” on their car loan. This can cause a problem if you do not have gap insurance and the vehicle is totaled in an accident. In this situation, the car owner will owe more money on the car than what they receive from their insurance settlement. Being “upside down” on your car loan will also have a negative impact if you need to sell your vehicle. Next to credit card or other unsecured loans, I recommend placing a priority on getting out and staying out of auto loan debt.
Mortgages: I don’t recommend aggressively paying off your mortgage debt until you have eliminated the previous types of debts and especially not before you have saved a generous amount of money in your emergency fund (at least one year of your annual income). The reason that it is imperative to first focus on building an emergency fund before you aggressively try to payoff your mortgage loan is that doing so can potentially put yourself in a very vulnerable position in the event that you hit a difficult financial time. For instance, you may work to payoff your mortgage loan by applying your extra income to your mortgage payment. Let’s say after two years of doing this, you were able to reduce the principal by an additional $15,000. However, two years later you also lose your job and are having a difficult time finding a new job. Without adequate savings, this situation may make you vulnerable to having your house foreclosed on if you are unable to make your payments. If this happens, the $15,000 in additional payments that you made over the last two years was not only wasted, but it also wasn’t able to be used when you needed it the most. Getting your mortgage paid off is a worthy goal, however, it is important to try not to find yourself in a position where you become delinquent on your mortgage payments.
With that said, it may make more sense for you to apply a little bit of additional money to your mortgage payments each month even while trying to reduce other debts and/or tuck money away in your emergency fund. Just paying an additional $20 or $30 dollars per month on your mortgage can take several years off of your loan as well as save you thousands of dollars in interest charges over the course of a thirty year mortgage. If you do make extra payments on your mortgage loan, be sure to indicate with your payment that you would like the additional money to go towards your principal. Here is an online mortgage prepayment calculator to see how much you can save.
Student Loans: While graduating from college with a high amount of student loan debt can make one anxious, paying off student loan debt is one of the last debts that I would worry about paying off. It’s not that it makes financial sense to hold on to this debt, however, the consequences of having this debt during lean times are much lower than other forms of debt. The interest rate of government-backed student loan debt is much lower than the rates on credit card and other forms of unsecured debt. In addition, if you go through a rough financial period, agents of government-backed student loan debt have a variety of payment options to offer you, including an option to temporarily place the payments due on hold, known as forbearance and deferment. An additional advantage of student loan debt, is that when lenders pull up your credit history to determine whether or not to grant you credit, they often grade the existence of student loan debt differently than other types of debt when considering the total amount of debt that you are carrying. The reason for this is because they consider this debt to be an investment in your income potential as well as income security.
Unpaid Medical Bills: With the rapid increase of medical costs as well as the incline in the amount of people with zero or inadequate health insurance, more people are finding themselves with large sums of unpaid medical bills. If you find yourself in this position than getting rid of this debt type would be last on my list of priorities. While it is important that you work with the institution or collection agency with agreeing on a monthly payment amount, this type of debt typically doesn’t carry any interest charges or late fees and lenders are usually forgiving when looking at this type of debt when considering whether or not to grant you credit.
For help managing and tracking your debt I recommend purchasing software such as Quicken. Quicken is a sophisticated personal finance software that makes it easy to set up your debt reduction goals, track your progress, set up a budget and more. Click here for a downloadable version of Quicken.