How to Determine Which Debt to Pay Off First

Managing debt can be overwhelming, but prioritizing which debts to pay off first can make a significant difference in your financial health. Generally, it’s best to start with credit card debt, as credit cards often carry the highest interest rates. By focusing on paying off credit card debt first, you can save money on interest and potentially improve your credit score. This is because reducing credit card debt directly impacts your credit utilization, a major factor in credit scores.

Here’s a comprehensive guide to help you eliminate credit card and loan debt one by one.

How to Determine Which Debt to Pay Off First

Begin by sending extra money to the debt with the highest interest rate or APR. This approach helps you cut down on the principal balance of your debt, reducing the amount of interest you pay over time.

Typically, credit card interest rates are higher than loan interest rates. As of February 2023, the average credit card APR was 20.92%, according to Federal Reserve data. In contrast, the average personal loan interest rate was 11.48% for a 24-month loan. However, personal loan rates can reach as high as 36%, depending on your credit profile and other factors.

One exception to this rule is payday loans. If you have a payday loan, prioritize paying it off first, even before credit cards. The fees associated with payday loans can equate to an APR of more than 400%, making them extremely costly.

Benefits of Paying Off Credit Card Debt First

Here are some compelling reasons to prioritize paying off credit card debt:

Strengthened Credit Score

Paying down credit card debt decreases your credit utilization ratio, which measures your credit balances compared to your credit limits. High utilization can negatively impact your credit scores. Reducing this ratio can significantly improve your credit score, as credit utilization accounts for 30% of your FICO® Score.

Less Interest to Pay Off

The longer you hold credit card debt, the more interest you’ll pay. By paying off credit cards first, you prevent high interest charges from accumulating over time.

Reduced Temptation to Spend

Paying off a credit card and removing it from your regular financial rotation reduces the likelihood of building up debt again. While it’s usually better for your credit to keep accounts open, using the card sparingly or for specific payments can help you avoid future debt.

How to Pay Off Debt

If you have multiple credit cards and loans, start by listing your current balances, APRs, minimum monthly payments, and due dates. This will help you plan your payoff strategy. Here are a few methods you can use:

Debt Avalanche Method

The debt avalanche method involves targeting the debt with the highest APR first. Pay as much as you can on this debt while making minimum payments on the rest. Once the highest-rate debt is paid off, move to the next highest rate and repeat the process.

Debt Snowball Method

The debt snowball method focuses on paying off small balances first. While this approach may not save as much money as the debt avalanche method, it can provide a series of small wins that motivate you to continue paying off debt.

Balance Transfer Credit Card

If you have good or excellent credit, consider a balance transfer credit card. This allows you to move multiple credit card balances to a single card, potentially at 0% APR for a period of time. Pay off the balance before the promotional period ends to avoid higher interest rates.

Loan Refinancing

Refinancing involves taking out a new loan at a lower interest rate to pay off existing loans. This option is available for car loans, mortgages, and student loans. Refinancing can save you money on interest, especially if you pay off the new loan quickly.

Debt Consolidation Loan

A debt consolidation loan allows you to combine multiple debts into a single personal loan with a fixed monthly payment. This option is most effective if the interest rate on the consolidation loan is lower than the average rate of your current debts.

Which Loans Should You Pay Off First?

Similar to credit card debt, focus on paying off loans with the highest interest rates first.

Personal Loans

With an average APR of 11.48% for a 24-month loan, personal loans often have higher interest rates than other types of loans. Consider paying down personal loans after making progress on your credit cards.

Student Loans

There are two types of student loans: private and federal. Private loans are often more costly and come with fewer benefits. It makes sense to pay off private loans before federal loans to save on interest.

Car Loan

The average interest rate on a new car loan was 6.58% in the first quarter of 2023. Car loans are usually smaller and more manageable to pay off quickly compared to mortgages.

Mortgage

As of June 2023, the average 30-year fixed mortgage rate was 6.67%. Mortgages are large, long-term loans, making them less of a priority compared to other debts. If your mortgage rate is higher than current rates, consider refinancing.

The Bottom Line

The most important step is deciding to focus on debt payoff. Start by targeting balances with the highest interest rates, typically credit cards. This strategy helps you save money on interest, freeing up cash for other debts and financial goals. While paying down your debts, monitor your credit and watch for improvements in your credit scores.

For personalized mortgage services, contact O1ne Mortgage at 213-732-3074. Our team is here to help you navigate your financial journey and achieve your goals.