Which Type Of Debt Should You Pay Off First?

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At one point or another, you’ll be struggling with debt throughout your life. Sometimes, debt results from unfortunate life events that are beyond your control, and sometimes, it may result from wrong financial decisions. Sometimes, it may even come as a result of your old debts, as you are forced to take on new ones to attend to the old. However, transferring your balances was never a good thing, except of course if the terms for the new debt are better.

But before going to explore that option, it pays to know there are actually ways to pay off your debts without the need to take out a new loan. It all depends on the debt repayment strategy you are most comfortable to follow. Basically, there are three approaches on which type of debt you want to pay off first.

Your Smallest Debt

Also popularly known as the debt snowball method, this approach of debt repayment requires paying off your smallest debts first, regardless of the interest rates. The method involves listing down all of your debts in order of the smallest to the largest, with interest rates only bearing weight when two debts have exactly the same amount, in which case, the one with the higher interest should be written down first. You should also assign a specific amount out of your budget towards paying off your dues.

Once the order of your debts is arranged, you need to start making only minimum payments towards your debts, except your smallest debt. All the money that is left after paying the minimum should be put towards that debt, until the debt is completely cleared. After that, the exact amount you allotted for your first debt, plus any excess amount out of your budget should be spent on your second smallest debt, still paying only the minimum on the rest. You should do this continuously until all debts are cleared. By the time you have to pay off the larger debts, you’ll have more money allotted, similar to a snowball that gets bigger as it rolls.

Pros

Promotes a sense of fulfilment. The good thing about this method is that getting one debt cleared immediately promotes a sense of fulfilment. It makes you get rid of one problem sooner so you’ll now have less to face.

Easier to stick to over the long haul. Because smaller debts are easier to pay off, there’s a higher likelihood of success when following this approach. Because results are seen immediately, the person becomes more inspired and more likely to commit over the long term.

Cons

More expensive approach. Because this method focuses only on the amount of debt, the higher interest rates debts are often left out. This means these debts have more time to accrue, and in the long run you’ll end up paying more.

Does not address the root cause of the debt problem. The approach tends to be an easy, more relaxed approach. It doesn’t teach the borrower to make significant adjustments in one’s budget, since the method is less strict compared to paying off high interest rate loans first.

Your Highest Interest Debt

On the other hand, the highest interest rate debt is the direct opposite of the snowball. According to this method, the debtor should focus on paying the debt with the highest interest rate first, because leaving them unsettled will get you into larger debts in the future. This is often considered as the mathematically correct and the most logical approach.

Pros

More cost-efficient. Paying off the highest interest rate debt is simply the way to go if you want to save money, no question about it. Basically, you are giving the debt’s interest less time to grow, thus saving you from all the unnecessary costs.

The later part of repayment becomes easier. If you are someone who’d rather work hard now and relax later, then this method is for you. In the beginning, it may seem that all your efforts are futile, and your debts are not getting reduced. But as you’ve slowly overcome the biggest and most difficult hurdles, you’ll be more comfortable as you face smaller and easier debts.

Cons

Can be exhausting. When you have a very large debt that has the highest interest, it can take time to get rid of it. This may make it harder for you to commit because results are not seen immediately.

Your Debt With the Highest Emotional Impact

Lastly, you can also pay off debts according to their emotional impact. It is also called by proponents as the debt tsunami method. According to the debt tsunami approach, there’s a higher likelihood of success when you pay off your debts in order of their importance and significance in your life. It may be that a debt from your relative brings about the greatest impact on your life, or it could be that your largest debt prevents you from sleeping peacefully at night. Whichever it is, getting rid of it as soon as possible can help you get back on track and work on your other obligations with the right mindset.

Pros

Can save relationships. Owing from people you know and have established relationships with is never comfortable. If you’ve been stressing over a particular debt and are worried that it can affect your relationship with that person, then perhaps getting it out of the way first can be the best approach.

Cons

Not the most economical approach. While it could be that your debt with the highest APR affects you the most, the method most often focuses on your emotions rather than logic. Sometimes, it could mean that you are losing money in the process.

There’s no single, correct method of paying off your debts, because everyone has different perspective regarding debt repayment. What matters is that you create a plan, start acting, and stick to it until the very end.

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