Here’s how to decide what debt you should pay first

Not all debts are created equal. So how should you decide to pay off debt first?

Between last year’s coronavirus pandemic and the recession that followed, debt piled high for many Americans. In 2020, consumer debt skyrocketed to a new high of $14.88 trillion, up 6% year-over-year, according to credit rating firm Experian.

Today, the average American is in debt more than $92,000, according to Experian data. Included in that total are various types of debt, including credit cards, student loans, mortgages, and more.

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As the United States emerges from the pandemic and Americans begin to return to the new normal, some may be looking to actively pay the bills they’ve accumulated over the past year.

Here’s how to determine which debt should be paid first.

Find a Debt Hierarchy

Before deciding on a debt repayment strategy, experts recommend determining which debt gives you the most headaches. This way, you can make that payment up front to improve your financial situation.

“It’s important to differentiate that and know that and focus on where the debt is really detrimental,” says Chris Lyman, a certified financial planner at Allied Financial Services in Newtown, Pennsylvania. best.

For his clients, Lyman prefers to divide debt into three “zones” – red, yellow, and green.

Red zone debt, which usually has the highest interest rate, is the one that causes the most damage. This includes things like credit cards, personal loans, and some private student loans. For example, interest rates on credit cards can go up to 30% and can even compound daily, meaning they can quickly grow even more if they don’t pay off.

Debt in the yellow zone has a lower interest rate, usually has a longer term, and can have some tax advantages, such as a home equity line of credit, federal student loans, both of which are There are some deductions. Lyman will also include auto loans in this category, because many people decide to take them on instead of paying off the car in full.

According to Lyman, a green debt is the longest term with the lowest interest rate and is anything that helps you build assets. This includes mortgages – interest rates can be as low as 2% – as well as some business loans.

“It’s not just weighing you down,” says Lyman. “There are several types of offsetting assets under construction.”

According to Delano Saporu, CEO of New Street Advisors Group, a financial planning and portfolio management firm in New York, there’s another way to think about prioritizing which debt to pay off. Think about the debt that weighs on you. This is usually consumer debt from a credit card, so it’s the best place to start, he says.

“It’s like the feeling of drowning when you have to pay off consumer debt, interest rates are so high,” he said. “You’ve bought things that you don’t really need, you just want, and so it leaves a feeling of despair.”

In terms of the pandemic, some people may also face other types of debt that don’t necessarily come with interest rates but can have a big impact on their lives, such as monthly rent debt. According to Saporu, it is also a debt that should be given top priority.

Avalanche vs. snowball

Once you’ve categorized your debt and know what you want to focus on paying off first – while making minimum payments on all other debts, of course – then you need to decide on a repayment strategy. .

Before you start allocating a portion of your budget to pay off debt, financial experts recommend that everyone accumulate at least a small emergency savings fund. Reason? Without a cushion, any emergency or even life surprise – such as an illness or your car breaking down – can send you into a deeper pit.

Once you’ve got your emergency savings in place, there are two popular repayment strategies that financial experts recommend – the avalanche method and the snowball method.

With the avalanche method, you pay off the debt with the highest interest rate first, then move on to the next highest interest rate and so on. Over time, those who choose this method will pay less interest by weeding out those with high interest rates first.

This is recommended for those who are disciplined and can stay on course, Lyman said. The debt with the highest interest rate may not be the smallest, and so using this method can feel like running a marathon instead of a sprint.

Snowballing is better for those who want to make quick progress, celebrate small wins, and use that momentum to tackle larger debt. In this method, you start with the smallest balance first.

“Mentally, getting some debt to zero makes people feel good,” says Saporu. “Especially if you’re young and you’re building cash flow, increasing your income, it’s a great way to feel better one step at a time.”

According to Saporu, as you progress in your career and income, you can deal with larger debts.

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