It Matters Which Debts You Pay First. Here’s Why.

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There are several schools of thought when it comes to paying off debts. If you have several different debts you’re working to pay off, it can seem overwhelming and stressful. Would it be best to pay off the oldest debt first? Or maybe the debt with the highest interest? All of them at the same time?

All of these are valid and reasonable questions. Which debt should come first? Unfortunately, there is no one-size-fits-all answer. However, there are a few different routes you can take and this article provides some good insight on which debts to prioritize.

Which Debts Should You Pay Off First?

When it comes to paying off multiple debts over time, there are different routes people choose to take to eliminate debt. Your repayment plan is 100% dependent upon what types of debts you have and how urgently they need to be paid off. In order to decide how you should go about reducing your debt, it’s important to keep these three factors in mind:

  1. Amounts owed on each account
  2. Interest rates on each account
  3. Legal implications if debts go unpaid

If you fail to make payments on certain types of loans, you run the risk of seriously damaging your finances and credit score. Some may even result in jail time, garnished wages, and even higher interest fees. These types of debts must be handled first before anything else. Here are some examples of urgent debts that should be paid immediately:

  • Back child support payments
  • Owed income taxes

Once you have a handle on the more severe debts, it can be extremely helpful to have a plan in place for repaying all other debts. There are several different strategies out there for repaying multiple debts at once. While you might think that paying off credit cards first is probably the best move, you could have other debts that are even more of a priority.

Snowball Method vs. Avalanche Method

The first step to tackling multiple debts is to settle on a method of paying them down. It’s crucial to go into the process with a clear plan of attack. That way, you can stay organized, motivated, and focused on your goal. Two of the most popular methods to paying off debt are referred to as the snowball method and the avalanche method.

Snowball Method

The snowball method was coined by Dave Ramsey, an American radio show host and businessman. This method is a debt-reduction strategy that focuses on paying off your debts in order from smallest to largest.  So every time you pay off a debt, you gain momentum and continue to knock out the debts one by one.

Once you pay off your first debt, you roll the minimum payment you were making on that debt to the next debt – thus gaining more and more momentum. Here is a step by step breakdown:

  1. Make a list of your debts from smallest to largest.
  2. Make the minimum payment on all accounts each month except for the smallest debt.
  3. For the smallest debt, make the highest payment that you’re able to.
  4. Repeat this process until all debts are paid.

By starting with the smallest amount, you will see quicker progress in your goals being actualized and it will help you stay motivated in taking on your next challenge.

While this idea seems to make sense on the surface and could be a great way to drive you towards your goal, the downside to this method is that it may take longer to complete and will result in higher interest paid overtime.

Avalanche Method

The avalanche method is another popular debt-resolution strategy. Unlike the snowball method, it focuses on tackling the highest interest rate debt first. So if you have credit card debt with 26% annual percentage rate (APR), it would come before a loan with only 15% APR.

By taking this approach, you will most likely be saving money in the long run by eliminating the risk of paying more in compounding interest fees. Interest can grow exponentially if left unchecked, so it seems reasonable to use this more ambitious method if you’re looking to pay off debt quickly.

Here are the steps to this method:

  1. Make a list of all your debts in order of interest rates from highest to lowest.
  2. Make the minimum payments on all accounts other than the one with the highest interest rate.
  3. Pay as much as you can on the highest interest debt until it is settled.
  4. Repeat until all debts are eliminated.

A possible downside to this method is that you may not see the results you’re looking for as quickly as with the snowball method. It all depends on what motivates you; some are motivated by the sense of progress, and others are motivated purely by numbers.

Prioritizing Your Debts

Here is a list of 11 different types of debt and their importance ranked from most important to least important. The idea is to start by paying the debts that can cause major legal ramifications if unpaid, then go on from there. This list won’t be 100% accurate in each case, but it can provide you with some insight on how to view the importance of your own debts.

1. Back Child Support Payments

Even though high-interest rate credit card debt can compound over time and needs to be paid off immediately, at the very least, it won’t land you in jail. Not paying back child support payments, on the other hand, could. Aside from the threat of jail time, not paying child support can result in having your wages garnished. It can also seriously put you at risk of having your driver’s license and other professional licenses revoked.

As if those repercussions weren’t bad enough, the government also has the power to place a lien on your property, put a boot on your car, and even intercept your tax refund. With this in mind, there’s no doubt that paying back any delinquent child support payments should be your priority.

2. Owed Income Taxes

While not as bad as being late on your child support payments, being indebted to the government is never a great position to be in.  The amount of interest and fees that can be racked up by unpaid income tax can seriously damage your credit and cause your debt to spiral out of control.

Even worse, to get their money, the federal government can put a tax lien on your property, garnish your wages, and also seize your personal property as a form of repayment. Money in bank accounts, as well as retirement accounts, can also be taken by the feds if you have any unpaid income tax. To avoid these disastrous scenarios, make sure to pay any owed income tax in full.

3. Car Title Loans

Car title loans use the value of your vehicle as collateral and should generally be avoided. But if you ever take one out, make sure you’re able to pay it back quickly. These loans can have over 25 percent monthly interest, which comes out to 300 percent annual interest.

If you miss a payment, the lender can repossess your vehicle. If they repossess, they will typically sell your car at an auction. And to make things even worse, they can have you pay the difference between the selling price and the balance of the loan. Be sure to pay off these loans immediately to avoid this.

4. Missed Car Payments

Much like car title loans, you don’t want to miss a couple of consecutive payments on your car loan. This can also give the lender the right to repossess your vehicle. Stay away from this mistake, and pay your car payments on time every month. While it’s not as bad as unpaid car title loans, this is a debt you should prioritize paying off.

5. Missed Mortgage Payments

Missing a mortgage payment could be seen as slightly better than a missed car payment. This is only because it can take over a year for a foreclosure to become finalized, which could theoretically buy you some time to get your financial situation straightened out to start paying back missed payments.

Not paying them back will seriously damage your credit score, which could ultimately hurt your ability to keep your house and buy or even rent in the future.

6. Defaulted Student Loans

Federal student loans default after nine months of missed payments. After the first missed payment, your credit score will start to fall and continually get worse until collections assume control of the account. Student loan debt that has gone into default due to missed payments can be especially scary if you consider the interest rates and fees charged on these loans.

FAST FACT: According to an office of The U.S. Department of Education, the current interest rate on a federal student loan can be as high as 6.2 percent.

Additionally, defaulting on these loans could result in the government garnishing up to 15 percent of your wages. The lender can also file a lawsuit which could result in a higher percentage of your wages being garnished.

Even if you negotiate to pay a lower amount with a collections agency, the original amount will still be shown on your credit report, with the difference displayed as a write-off. That fact alone can significantly damage your credit score, which is why paying off late student loan payments should take precedence in what debt you pay off first.

7. Payday Loans

Payday loans can be some of the riskiest loans you can take on. They carry an annual amortized interest rate of over 400 percent! Getting behind on these loan payments can leave you paying thousands more than you borrowed in the first place.

Unpaid payday loans can also result in being taken to court by a collection agency that decides to sue you for the debt you owe. If you lose the case, you’re more than likely to have a judgment listed on your credit report. Additionally, you face the threat of wage garnishment as a form of repayment of that debt. Don’t get yourself into this situation and pay off any payday loans immediately.

8. Medical Bills

Medical providers can be pretty lenient when it comes to small amounts less than $100 owed. But if you owe thousands of dollars that you haven’t made a payment on in more than three months, you should anticipate a call from a medical collections agency in the near future. This process could lead to lawsuits and even more in post-judgment payments.

9. Money Owed To Friends

Borrowing money from a friend or family member is something you should always carefully consider before doing. If it’s necessary, be confident that you will have the ability to pay them back. Relationships can be hard enough to manage without the overwhelming stress of knowing that you owe your friend money you can’t pay. This is why it’s important to stay true to your word and pay off any debts you owe from loans you took from friends or family.

If you’re borrowing money from a friend or family member, or if you’re lending to a friend or family member, make sure you have a written personal loan agreement in place to clarify the terms of the obligation.

10. Credit Card Balances

Credit card balances are notoriously difficult to pay off if you’ve gotten into a situation where you’re close to maxing out your available credit. Just making the minimum payment on a $5,000 balance would take you many years to pay off and would amount to thousands more paid interest over time.

If you’re not making the minimum payment and haven’t even made a payment in six months, you could be in danger of destroying your finances and credit score. Not paying the monthly payment for an extended period could result in your credit card company closing the account and sending it to collections. This could once again result in you having to go to court to settle any lawsuits that could come your way from the collections agencies.

11. Collections

The lowest on the list of priorities of debt to pay are collections agencies. While collections agencies might be the last people you want to be dealing with when you’re drowning in debt, they are nothing to be overly concerned about.

Collection agencies typically deal with older debts, and luckily old debt has a statute of limitations. After that time has passed, these debts cannot show up on your credit report. This leaves the collection agency with little to no option other than to demand you to pay what you owe.

If you’re taking on new debt while paying a small portion of old debt, this could give the collection agencies the power to pursue legal action. However, if you are paying back just part of the old debt that has exceeded the seven-year time frame while not taking on any new debt, you have essentially hit the reset button and the debt doesn’t show on your credit history.

Takeaway

Having looked over the various types of debt and which ones should take priority in being paid off, it’s up to you to assess your financial situation and determine which of your debts you want to pay off first.

With child support and owed income taxes being the main priority, it is important to also account for any unpaid mortgage, student, car, car title, or payday loans. After figuring out which debts you need to prioritize, try one of the methods listed in this article to tackle the rest. Remember, paying off debts take time, consistency, and patience. You got this!

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