Gain a better understanding so you can be more strategic about managing debt.
This infographic breaks down types of consumer debt so you can understand your debts better. We’ve included some instructions below the infographic to help you prioritize debt repayment strategically.
How to prioritize debt repayment
First it’s important to note that prioritizing debts does not mean choosing which debts to pay. You should always make the required monthly payments on all of your debts each month. Prioritization refers to focusing extra money to pay off certain debts faster. This eliminates obligations and bill payments, freeing up cash flow in your budget while improving your credit.
- Revolving debts tend to have significantly higher interest rates than installment debts. There is usually also no restriction or penalty for paying more than the minimum required payment.
- That means credit cards and other revolving debts should be given high priority to eliminate first
- If possible, eliminate your credit card debts in order of highest APR to lowest; this will help you save money over the life of your debts.
- Once you eliminate all high interest rate revolving debt, review the loan agreements for your installment debts.
- In some cases installment loans have penalties for making early payments or extra payments; make sure to check penalties before you make any plans to accelerate how fast you pay off these debts.
- It may be better to eliminate installment debts by lowest balance first – i.e. you can pay off your auto loan in full much faster than you can eliminate your mortgage, even though the latter may have a lower interest rate.
Weighing savings versus debt elimination
Many people make the mistake of failing to plan savings into their household budget. In many cases, people say they need to eliminate debt before they can begin to save. However, that’s often only partially true.
Savings should be factored in when the savings rate is larger than the interest rate applied to a debt. In other words, if savings can grow as fast, or faster, than interest charges applied to a debt then you should make savings the priority.
However, for debts like credit cards that carry high interest charges it makes sense to pay them off as quickly as possible and then implement a robust saving strategy. In most cases, the growth you see from any savings or investing tool will not outstrip how fast a rewards credit card with APR of 20 percent or more can accrue interest.
On the other hand, if you have high credit card balances that could take up to 5 years to pay off, then it may be creating added financial risk if you do nothing to save during that time. Savings is often used to create financial safety net that you can fall back on for unexpected expenses and emergencies. If you don’t have that safety net, emergencies often end up on credit cards so you add to the debt you’re already struggling to eliminate.
In this situation, consider options like enrolling in a debt management program. This can reduce your total monthly credit card payments by 30 to 50%. The cash flow that’s freed up by consolidating credit card debt can then be used to build savings. By making a plan to eliminate your debt in a more effective way, you have money to allocate for saving at the same time.