When you’re expecting an increase in income or a windfall of cash, such as a tax refund or annual bonus, you may start thinking about paying down your debts. Becoming debt-free is a goal many folks have, and for good reason. Being accountable for debts that cost hundreds or thousands of dollars every month can be stressful, not to mention a major drag on financial progress.
The situation for most people, however, isn’t always straightforward. It’s common to have numerous types of debt to pay off, from auto loans to credit cards to collections accounts. So which ones should you tackle first? The answer isn’t often easy, so we whipped up this article to help you make the best decision for your financial future. Here are seven factors to consider when prioritizing which debts to pay off first.
Which Debt Should You Pay Off First?
Motivation From Momentum
The motivational rush you get from paying a debt off is real. With each account paid off, you start to feel a sense of accomplishment that strengthens your resolve to become debt-free. This effect can be leveraged to your advantage by tackling the smallest debts first to build momentum. Each time you pay an account off, you’ll be increasingly empowered to achieve financial freedom.
When starting to consider which debts to pay off first, run down the list of the rates you’re paying on each account. If you have significant amounts of credit card debt, you might have rates as high as 30% or more. This is why people with goals of becoming debt-free as fast as possible should start paying down the debts with the highest rates first.
Once you’ve ranked your debts by interest rate, next, rank them by how the interest is charged. If the interest is simple, like an auto loan, it will be less difficult to pay off compared with revolving debt that can build with each passing month.
How Interest Is Charged
How is the interest being charged on each debt? If the debt has a simple interest loan with a low rate, like a student loan, it could be better to pay other debts off first. One example is revolving debt like credit cards. With this debt, the way the bank charges you interest makes it far harder to pay down your balances.
Revolving debt is more difficult to pay off when you maintain a balance from one month to the next. That’s because carrying a balance over to the next month often results in interest being charged on the interest charges from the previous months.
For example, if your interest charges for one month are $168, but you only pay the minimum payment of $45 that month, you’ll add $123 to your balance. Then, you’ll be charged interest on $123 more the next month.
If you repeat this habit for months on end, your balance can quickly spiral out of control, making it next to impossible to pay the debt off. That’s why it’s so crucial to pay these types of debts down before simple interest loans, which only charge you interest on the original principal balance.
Potential Penalties And Fees
Not all lenders are created equal when it comes to fees and penalty charges. Some credit card companies charge $35 or more every time your balance exceeds its limit and may even hike your interest rate if you miss a payment.
Debts that have a high potential for excessive fees that inflate your balances should be a top payoff priority. Often, these are revolving debts like credit cards that already have high-interest rates. When you factor these fees in, it’s easy to see how revolving debt is so hard to escape. If you need help settling debts with creditors that are charging you excessive fees every month, Alleviate Financial can help. Contact us for a free consultation today.
Tax Deduction Possibilities
Sometimes the interest on debt is tax-deductible, potentially helping you save thousands in taxes year after year. One example of this is home loan interest, which is often able to be deducted on your taxes. Another example is interest on equipment for a business you own, which can usually be counted as an expense to reduce your taxable income. If your interest can be deducted, it’s probably better to allocate your money to pay down other types of debt instead.
Impact On Credit Scores
One of the leading factors for why people want to pay down their debts is to boost their credit scores. An example of how this works is the percentage of your account limit you’re using. This percentage is called your utilization rate, and the higher it is, the more your credit scores are negatively impacted. By simply going over the 50% mark, you could potentially wind up paying higher interest rates on new loans for things like cars and houses.
Another type of debt that’s even more important for credit scores is collections and charge-offs. Having accounts like these on your credit report causes a huge drop in scores, so it’s critical to pay these off first if increasing your credit scores is your primary concern.
Trying to work out settlements with these companies can be a challenge, requiring time on the phone and a thick skin for negotiations. Alleviate Financial can take on these creditors for you, helping you get the best possible debt settlement agreement.
Debt Settlement Potential
Another factor to consider when choosing which debts to pay off first is the potential for settling the debt. If you have collections accounts or credit cards that have gotten out of control, debt settlement could slash your balances so you can become debt-free sooner. By leveraging the help of a debt settlement company like Alleviate Financial, you can make your money go much farther when trying to pay down your debts.
Debt Settlement Programs That Make A Difference
When your debts are costing you hundreds in monthly payments and growing, your ability to get ahead financially can feel hopeless. Thankfully, Alleviate Financial is here to help you become debt-free in less time and reach your full financial potential. Get started today!