When you have debt to pay it can feel like you’re carrying around a weight on your shoulders every day. But what happens when you have a mortgage, a car loan and a credit card to pay off all at once?
Having multiple sources of debt can be overwhelming, as it is challenging for anyone to pay down all their loans at the same time with different interest rates and different payment schedules.
If you’re wondering which of your debts to pay off first, there are two popular schools of thought:
- Pay the debt with the highest interest rate first; or
- Pay the smallest debt first.
So, let’s explore which option may best suit you when deciding which of your debts to pay off first.
Deciding which debt to pay off first
Highest rate first
A major reason that multiple debts cause so much financial stress is that you’re typically paying multiple interest charges at once, causing your debt to snowball out of control. This is why some experts recommend the strategy of paying your debt with the largest interest rate first. This may help to slow the speed of your growing debt.
Generally speaking, this is typically your credit card. Consider making the minimum allowable repayments on lower-rate debts, such as your mortgage or a car loan, so you can devote the maximum amount of money to higher-rate debts.
Smallest debt first
The other strategy to consider is clearing your smallest debts first. This can be very motivating, as you get an easy win that may push you to pay off your bigger debts. Plus, you’ll free up room in your budget to put towards the rest of your debts.
For example, if you have two credit card debts, you may consider paying off the smallest debt first - regardless of the interest rate - so that it is out of the way. Then you can focus your financial resources towards the bigger, scarier debts.
Should you make extra repayments toward a loan or a credit card?
Let’s say you have room in your budget to make extra repayments towards your credit card or a personal loan. Which one should you choose?
Loans are designed to be paid off over a fixed period of time, assuming you meet your repayments. If you agree to borrow, say, $15,000 over a four year term, you should have this debt cleared over this time if you make your regular payments.
Comparatively, minimum repayments on a credit card are typically $20 or 2% of the balance - whichever is greater. As you make minimum repayments, your credit card balance will continue to grow as you will still be charged interest on an outstanding balance.
For example, if you have a $5,000 outstanding balance on your credit card with a rate of 16%, by only making minimum repayments it could take you 27 years to pay this off and cost you an extra $8,659 in interest charges.However, if you made higher repayments you could have this debt cleared in months or a few years.
Because of this, it may be worth considering paying off your credit card balance as a priority. As long as you’re meeting your minimum payment requirements for your loan, the debt should be paid off in time.
Making extra repayments to clear a personal loan early, while helpful, doesn’t necessarily change the fact it will still be paid off. However, making extra repayments on a credit card could save you decades of debt pain and save you thousands in interest charges.
Consolidating your debts
There is a third strategy to consider if you’re seriously struggling to get your debts under control; a debt consolidation personal loan. This is a type of loan that allows you to roll all of your debts into one.
The debt consolidation loan lender will essentially clear your debts with the other banks and lenders, allowing you to streamline your repayments towards one, easy-to-follow debt with one interest rate. A debt consolidation loan may allow you to:
- Easily budget for and track your debts
- Save on annual fees with multiple lenders
- Improve your credit score once the debt is paid off
However, a debt consolidation loan is still a form of debt. It is crucial you compare your options carefully, and look at factors like the interest rate and any fees charged, before you proceed. This strategy may only suit those who have the budget for paying off a larger debt, as opposed to using one of the strategies above. It may also be worth seeking expert advice before consolidating any debts to ensure you understand all the potential costs.