There are two general schools of thought when it comes to which debt you should pay first. Neither way of thinking is better than the other. The approach you take simply depends on your preferences and the factors that best motivate you to keep paying down debt.
One approach is to work on the debt with the highest interest rate first. All things considered, this is the approach that you should take if possible, since it will save you the most money in the long term. High interest rates are a huge financial drain, and the sooner you get rid of debts that carry these rates, the better. For instance, suppose you have four debts, a mortgage at 4.3 percent interest, a student loan at 8 percent interest, a credit card at 13 percent interest and a car loan at 5 percent interest. With this approach, you would pay off the credit card first then move on to the student loan.
However, there is a valid reason why you might not want to use this approach. It’s psychological. People like to see progress being made, and if the debt with the highest interest rate is also large and will take years to pay off, you could become discouraged. If this seems likely with your personality style, consider the approach below.
The second school of thought encourages you to pay down the debt with the smallest amount first. This approach offers mental boosts on several fronts; you’re wiping out debts more quickly and owe fewer companies/lenders. So, if you have four debts, a mortgage that you owe $100,000 on, a student loan you owe $3,500 on, a credit card you owe $8,500 on and a car loan that you owe $7,000 on, you would pay back the student loan first because it is the smallest amount. Afterward, you would move on to the car loan and then to the credit card debt.
However, before you begin focusing on one particular debt, ensure that you have an emergency fund that covers three to six months of living expenses. Otherwise, you risk having to go further into debt if an emergency occurs.
Advertising Disclaimer: Simple. Thrifty. Living. does receive compensation for some of the services that we recommend, although we only recommend services that we truly believe are the best.