Learn How to Prioritize Debt With These Tested Steps
When you have any amount of debt, it can feel like you have a weight crushing you. The average person has a substantial amount of debt. It can feel like there is no way to get out from under it. As your debt grows, you feel like you have no control and will never be able to get control of your debt. While it may feel this way, it is possible to get your debt under control. It is essential that you understand the best way to pay off your debt. When you know how to prioritize debt, you can begin to feel like you are on the road to paying off your debt.
How to Prioritize Debt
When you have debt, it has an impact on the money you have to spend each month. Debt is typically considered a payment that you have to make that provides no value to you. For example, a mortgage is a debt that has value. As you pay your mortgage, you a paying off your house, which means you own more of it, and the bank owns less. As you pay off your mortgage, you own the home. You are also building up equity in the house. Credit card debt, on the other hand, does not work for you. It works against you in many cases. Every time you use a credit card for purchases, you are borrowing money to purchase something. When you pay off your credit card, you have nothing to show for it. When you have too much credit card debt can hurt your credit score.
The more debt you have, the more critical it becomes for you to be smart when paying it off. There are two ways to prioritize your debt. You can do that by the interest rate or based on how much you owe or the balance for each debt.
Interest Rates
When looking at the interest rates on your debt, it is helpful to know that the higher the interest means, the more money you pay on your debt. When prioritizing by interest rate, you put them in order from highest to lowest. Some refer to this as the avalanche method for paying the debt. This is also the way to save the most money when paying off debt. Your debts accrue more interest the longer you have them.
There are two types of interest debt can have: simple interest or amortizing. Most often, mortgages and car loans are amortizing loans. This type of loan has a fixed payment amount, but a more significant percentage of that payment goes toward interest and not the principal at the beginning of the loan.
An example could look like this:
Your first payment on your loan is $430.33, and $405.33 goes to the principal. $25.00 goes toward the interest.
Your second payment is still $430.33, but $407.36 goes towards the principal, and $22.97 goes toward the interest.
Finally, your third payment is $430.33, with $409.40 going toward the principal and $20.94 going toward the interest.
As you can see, with each payment, the amount you pay toward interest decreases. Early on in the loan payment, you are paying less towards the principal, which is the actual amount you borrowed. It is better to pay off loans that are amortized first because you end up paying more money over time the longer you have these loans.
Here is an example
This example will help you to highlight why you should pay off the debt with the highest interest rates first.
If you have a five-year loan with 10% interest, the interest rate impacts how much you pay. To make this example more straightforward, we will use simple interest at a fixed rate.
- Loan With the Higher Interest Rate:
- 5 years = 60 months
- Loan amount = $20,000
- 20% interest = $4,000
- Total amount borrowed = $24,000
- Monthly payment = $400
- The Same Loan with a Lower Interest Rate:
- 5 years = 60 months
- Loan amount = $20,000
- 10% interest = $1,000
- Total amount borrowed = $21,000
- Monthly payment = $350
While the numbers may seem small in this example, $50 each month could be significant. This is because paying off the loan with the higher interest first gives you more money each month.
Balance
Another way to consider prioritizing your debt is by the balance you owe. This option will not pay off your debt the fastest way, but it helps you see your number of debts reduce. If you have several debts, this may be the approach that feels best for you. This focuses on the psychological impact of debt. For some, knowing they have several different debts makes it feel like they are at the bottom of a huge mountain.
The way this works is you gather all the information you have collected about your debts, and you put them in order by balance. The balance is how much you still owe on the debt. This is not how much you borrowed but how much you owe. You pay the minimum payment on all of your debts except the highest balance. You pay as much money as you can on this debt to reduce it faster. Your other debts are being paid, but just the minimum payment and you focus all of your money on the most significant balance.
- If you have:
- Personal Loan = $2,000
- Credit Card #1 = $5,370
- Credit Card #2 = $10,935
- Personal Loan = $4,364
- You would consider paying them off in this order:
- Credit Card #2 = $10,935
- Credit Card #1 = $5,370
- Personal Loan = $4,364
- Personal Loan = $2,000
Keep in mind that the order above may not focus on paying the debt with the highest monthly payment first. Instead, you are focusing on the total balance.
Which Prioritization Method is Best?
Many people may think that the interest prioritization method is best because it allows you to save the most money. While that is true, and for some, this is the best method, it may not be accurate for all. There is a large number of physiological impacts of debt. It can weigh on a person and make them feel bad about their situation. For this person, the balance method may be the better option. It allows them to focus on the goal of reducing debt and seeing the number of debts they have to go down. This can be enough to encourage them to continue paying down their debt. It can also help them feel better about their financial situation.
The Snowball Method
This method takes the balance prioritization approach and flips it upside down. Instead of paying off your highest balance first, you pay off your lowest balance first. This method allows you to see results faster. When you are dealing with a number of different debts, this allows you to see more debt going away faster. You may not be reducing the debt that costs you the most, but you see results. For some, seeing results is necessary to keep going. For those that are results-oriented, this can help them cross off a debt that makes them feel successful.
Why Create A Budget?
When you want to know how to prioritize debt so that you can pay it off quickly, it helps to start with a budget. While a budget may seem like a difficult thing to create, it is necessary. When you do not have a budget, you have no idea how much money you have to spend each month. In addition, you probably have no clue where you even spend your money each month. When you create a budget, you have a true accounting of how much money comes in and goes out on a monthly basis.
Not only can you see how much money you have each month to pay down your debt, but you can see where you spend money. This allows you to see where you can make changes with regular spending. For example, if you buy coffee every morning, you can see how much it costs. This may prompt you to make coffee at home instead. That coffee money can be spent on paying down debt. It may seem silly, but it adds up quickly.
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Still Need Help?
Many people do not understand how debt works because they were never taught. This does not have to be the case for you. The Goalry Mall is here to help.
We have a wide range of educational materials for you. You can learn more about debt and how to reduce it. You can learn how debt impacts your credit. In the Mall, we have videos and articles and provide access to professionals that can guide you on your journey to being debt-free. In the Mall, we also offer budgeting, real estate, and investing resources. Come check us out and see all our resources to help you learn more about finances.
Conclusion
You have learned a lot about how to prioritize debt. Now it is time for you to take the first step in reducing your debt. While it may not always seem easy, it is certainly worth reducing your debt and freeing up more money for spending each month. You can also feel better about your financial situation when you have less debt and better credit.