Which Debt Should You Pay Off First?

Many people owe money to more than one lender. That situation often raises the same question: which debt to pay off first. The answer starts with your basic living expenses. Pay for housing, utilities, food, and work transportation before making any extra debt payments.

After you cover those essentials, the next step is a plan for the rest of your debt. A clear plan helps you decide where to start.

If you're current on every payment and on top of your accounts, a debt payoff plan is still worth the effort. A plan for which debts to pay off first, second, and third gives you a clear path forward and could help you save money on interest.

Prioritize Delinquent and High-Risk Debts

Delinquent accounts belong at the top of your list. These debts could hurt your credit score and, in some cases, lead to a lawsuit against you. Debt relief options, along with the payoff strategies below, could help you get current.

Secured debts, like an auto loan or mortgage, that are in delinquency are also priorities. An auto loan or home mortgage that goes unpaid for too long could mean a car repossession or a home foreclosure.

One more urgent debt priority: tax debt you owe to the government. Unpaid tax debt could mean owing additional interest and penalties, and tax debt generally survives bankruptcy. If you don't pay your taxes, the government may place a tax lien on your home or other property. A tax lien gives the government a legal claim against your property to secure the unpaid tax debt. The IRS offers payment plan options for taxpayers who owe more than they're able to pay right away.

Unpaid tax debt could bring severe and painful problems. Government authorities are generally easier to work with if you communicate with them early. Tax debt has many solutions that could fit your budget and help you move forward.

If you're going through financial hardship, like a serious medical problem, lost job, long-term unemployment, or the death or disability of a spouse or main breadwinner, it's even more urgent to prioritize your debts. To decide which debt you should pay off first, ask yourself if this unpaid debt could:

• Cause you to lose your home or property? If you're delinquent on your home mortgage or auto loan, prioritize these debts first so you don't lose your home or vehicle.

• Get you in trouble with the government? If you owe money to the IRS or state tax authorities, put that at the top of your list.

• Be handled in other ways, like debt relief? Some debts, like credit card debt and unsecured personal loans, may be negotiated and settled through debt settlement programs or other debt relief options. If you have several unpaid debts, you might want to put your credit card debts on the back burner and focus on keeping your home and car.

People without delinquent debts still need to decide which debt to pay off first. A plan and organized records could help you save money on interest and fees, get rid of debt faster, and build a stronger financial future.

There isn't one best way to get rid of debt. The best time to start is now.

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How to Choose Which Debt to Pay Off First

Many people choose to start with either the most expensive debt or the smallest outstanding balance.

For example, if you have three credit cards with interest rates of 25%, 27%, and 29%, you might want to pay off the highest-interest card first. Or if you have an auto loan with $2,500 left on it and $5,000 each on two credit cards, you might decide to pay off the smallest balance first, even if it's at a lower interest rate.

This choice takes some thought. To decide, you need to understand the type of debt you have, its cost, and its outstanding balance. Gather your debt information, including mortgages, student loans, auto loans, personal loans, and credit cards.

Secured vs. unsecured debt

A secured debt is backed by an asset, called collateral, that you offer the lender to get the loan. Mortgages, home equity loans and HELOCs, and auto loans are common examples, because a home or vehicle secures the debt. Secured debts generally carry lower interest rates than unsecured debts, since the collateral protects the lender. If a secured debt goes unpaid, the lender may seize and sell the asset to recover the balance, for example, through mortgage foreclosure or auto repossession.

An unsecured debt has no collateral behind it. Personal loans, student loans, and traditional credit cards are common examples; the lender relies on your credit history and your promise to repay instead of an asset. Unsecured debts generally carry higher interest rates, since the lender takes on more risk. Unpaid unsecured debt doesn't put your home or car at risk. It could still lead to added interest, fees, credit score damage, or a lawsuit.

Whether to pay off secured or unsecured debt first often comes down to your finances and your peace of mind. For example, someone with a 7% auto loan and 25% credit card debt often comes out ahead paying down the credit card first, while the car loan continues at its regular pace. 

• If you're delinquent on a secured debt, address it first to protect your home or car, even if that means paying only the minimum on unsecured debts. 

• If your secured debts carry low rates and your unsecured debts carry much higher rates, paying down the unsecured debt first generally saves more money. 

• Unsecured debt that's delinquent may be negotiated and settled through debt settlement programs or discharged in bankruptcy, so you may have options that don't put your home or car at risk.

Cost of debt and outstanding balance

The cost of a debt is best measured by its interest rate. Your annual percentage rate (APR) includes the interest rate plus fees, so it's a useful way to compare debts. Write down the APR for each debt so you know which ones cost you the most over time.

Know your outstanding balance and minimum payment for each debt. Credit card minimum payments drop as your balance drops, but a lower minimum payment means a longer payoff timeline. It's best to keep paying the same amount each month, even if your card issuer allows a lower payment. Installment loan minimum payments, like those on a mortgage or auto loan, typically stay the same until payoff.

Looking for debt relief in Indiana or across the country? The first step is the most important one—learn more.

Debt Payoff Strategies

Once you know the details of your debt, choose a debt repayment plan that suits you. Let's assume you have the following credit card debts:

Let’s say the minimum payments are $600, $259, and $142 (calculated as the interest plus 1% of the balance). You’re paying $1,001 per month, and a debt payoff plan works best if you keep paying that same amount until all debts are cleared.

Debt snowball: the smallest debt first

With the debt snowball method, you pay off your smallest balance first and work up to the largest. This method offers a psychological win instead: watching that first balance reach zero could help keep you motivated.

Using the example above, you'd make minimum payments on cards A and B while putting any extra money toward card C, the smallest balance. Once card C is paid off, you'd roll that payment into card B, then card A, until every balance is paid off.

The debt snowball method is good for most people. It’s the fastest way to your first debt payoff, and doesn’t require you to track interest calculations. Studies have shown that people who knock down smaller debts first tend to stick with their plan longer and have greater success than people who use the mathematical approach of the avalanche method.

Debt avalanche: the highest interest rate first

With the debt avalanche method, you pay off the debt with the highest interest rate first. The goal is to get rid of the most expensive debt first, which could save you on interest charges over the long run.

Using the example above, you'd make minimum payments on cards B and C while putting extra money toward card A, the highest rate. Once card A is paid off, you'd move to card C, then card B.

For this level of debt, at these rates and if you can pay an extra $100 per month, the avalanche could save you about $466 at the end of nearly five years. The avalanche and snowball methods take the same amount of time. You’ll save the money when you’re at that final payment.

Source: finred.usalearning.gov

Debt consolidation loans

Debt consolidation uses one loan to pay off multiple debts, often at a lower interest rate. It could simplify your finances by turning multiple payments into one. Here are three common ways to consolidate debt.

Personal loan. A personal loan used as a debt consolidation loan could offer a lower rate than credit cards if your credit is fair or better, and it's typically unsecured, so your home or car isn't at risk. The tradeoff: the debt doesn't go away. It moves to a new account. A common pitfall is to run up new balances on the credit cards you just paid off.

Home equity loan or HELOC. A home equity loan or home equity line of credit (HELOC) borrows against the difference between your home's value and your mortgage balance. Rates are typically lower than credit cards or personal loans. The loan is secured by your home, so missed payments put your home at risk of foreclosure.

Credit card balance transfer. A balance transfer moves your balances to a new credit card, often with a low or 0% introductory interest rate for a period of time, plus a transfer fee of about 4% to 5%. Balance transfers could meaningfully cut your interest costs. The rate jumps up once the introductory period ends, and qualifying generally requires fair or better credit.

Debt consolidation tends to work well if you have multiple high-interest debts, want a single simpler payment, and qualify for a lower rate. It's generally not the right fit if your debts are already delinquent or you'd rather avoid the temptation to take on new balances on paid-off cards. 

Common consolidation mistakes:

• Credit card accounts left open after consolidation, which often leads to new balances.

• A balance remaining at the end of the introductory period, when the rate increases.

• A home equity loan used to pay off credit cards, followed by missed mortgage payments, which risks foreclosure.

Alternative Debt Payoff Methods

Beyond the debt snowball and debt avalanche, a few other approaches could work depending on your priorities:

• Debt by type: Pay off one category, like credit cards, before moving to auto loans, then student loans.

• Highest payment: Pay off the debt with the largest minimum monthly payment first.

• Credit utilization: Pay down cards with higher balances first to help your credit score.

• Emotional priority: Pay off the debt that feels most urgent to you.

• Hybrid approach: Pay extra toward more than one debt at a time instead of following a single method.

There's no single right approach as long as you stick with your plan and your balances keep shrinking.

Methods to avoid:

• Frequent balance transfers, which may lead to rising credit card debt

• Minimum payments only, which generally means paying more in interest over a longer period.

• Retirement account withdrawals, since that money is difficult to replace later.

• Random debt payments without a plan to guide your progress.

Pros and cons of debt repayment strategies

Which debt repayment method should you choose?

The best debt repayment strategy depends on your finances and your personal style of managing money. Choose the method you're most likely to follow through on.

Create Your Debt Payoff Plan

Now that you know the ins and outs of debt payoff plans, it's time to build your own. Here's a quick step-by-step guide:

1. List and organize your debts. Gather your latest balances, interest rates, and minimum payments from your credit card and loan accounts into one place, using a notepad or spreadsheet.

2. Use tools and debt calculators. Free apps and calculators, like the Achieve GOOD app and Undebt.it, help you track your progress and estimate your payoff timeline.

3. Set realistic timelines. Paying off debt generally takes months or years of steady progress. A debt calculator helps you estimate your timeline.

4. Review your budget. Review your budget for extra money to put toward debt each month, which could speed up your payoff timeline.

5. Monitor your progress. Monitor your balances as they go down, make extra payments when you find additional cash, and celebrate milestones along the way.