All debt is not created equal so they shouldn’t be treated the same either. They come with different structures based on collateral, length of time, payment frequency, and interest rate. Sometimes it’s difficult to figure out which one of your debts should be paid off first that it becomes easier to just say “pay off the lowest interest debt first”.
This advice is neither wrong or false but it presents a deeper question that needs to be asked before doing anything. That question is “what does my financial picture look like?” Knowing your starting point helps with assessing your next steps to becoming debt free, or close to it.
I’ve been in this exact predicament for the past several months. At the beginning of this year, my goal was to pay off my Thrift Savings Plan (TSP) first because the interest rate was sub 3%. Compared to my credit card debt, I knew I would benefit from this mentally but I never gave any thought to how much of my income would go toward interest for the other debts that I had.
After I assessed my personal financial picture, I shifted my strategy toward wiping out the high interest credit card debt first. Then once that’s completed, I will recommence with the rest of the debt and apply the same principles to those.
If you ever thought about “freezing” your credit card, you might want to rethink that idea.
While getting rid of low interest debt first helps build momentum, if your financial picture includes high interest rate loans or credit cards, paying them off keeps more money in your pocket because that money isn’t being slaved away to interest. That money could be used for paying your remaining debt, saving towards a celebratory dinner, or even a family vacation.
Before you jump on the bandwagon to pay off your lowest interest debt, think about these factors first.
Assess your financial picture
Before beginning any debt paydown plan, assess your financial picture first. Perhaps there is a better angle to attacking debt than going after the low interest or low balance debt as your initial option.
Start with listing every single type of debt to your name. If you have a mortgage, credit card, or student loan, list them all down on a piece of paper. You need to see them all in front of you for the next steps.
If you need a quick reminder what type of debts you might possibly have, here’s a list for you to refer to.
- Mortgage
- Car loan
- Student loan
- Personal loan
- Credit card debt
- Rental property loan
- Debt repayment plan
- Line of credit (personal, home)
- Borrowed money from friends or family
Next, you’ll need to know how much is owed to each debt. This shouldn’t be difficult to figure out. A quick login to your online account will give you the balance remaining. Take this information and write it down next to each of your debt types you jotted down on the piece of paper.
Lastly, you want to note the interest rates applied by the creditor to you. Typically, you’ll see a low range (less than 6%) for a mortgage and a higher range (more than 16%) for credit cards.
Take your debt information (the balance owed and annual interest) and plug them into any online credit card interest calculator. If you have a number in mind of how much you are comfortable with paying each month, add that to the calculator too. If you don’t, it’s ok for now but it would be good to know. For now, just play around with the numbers.
The calculator will tell you a few important details. It can show you how many months (or years) until payoff and the amount you’ll pay toward principal and interest. These are important when factoring which debt you want to attack first.
After you run the numbers for each of your debt vehicles, look long and hard at the payoff dates. Give yourself a minute to think about how interest rates are affected by that payoff date. This should help in deciding what needs to be paid off sooner rather than later.
The higher interest rate paired with a minimal monthly payment equates to a lot more money out of your bank account for no reason other than making the bank happy. This is what helped me decide on ditching my low interest TSP loan to pay off all the consumer credit card debt to my name. I didn’t want to be forking out thousands of dollars more just because I wanted to be mentally happy.
Make minimum payments on other debt
When you’ve declared which debt is the number one priority, apply any and all extra money to clearing it from your name. You can pick up a side job. You could learn a side hustle. You could even lower your spending and use that extra cash towards debt. There are many ways to make more income or fix areas you overspend in.
For the other debts, we aren’t going to keep them stagnant. Creditors won’t allow that and they will get their money in the end. Instead, you want to make the minimum payments required to keep them off your back. This keeps them happy and it keeps more money in your wallet that you can then use to clear out the more important debts.
Just remember, at the very least, always pay the minimum amount for your lower priority debts.
Do a balance transfer
A balance transfer is a helpful tool. It can be used to repay existing debt with another credit card. How it works is you transfer the balance from your current card to a new credit card. This doesn’t reduce the amount you owe but you are typically getting a lower interest rate for doing it.
There usually is a balance transfer fee of 3-5%. But this fee can easily be outweighed by how much you’ll save from avoiding the high interest rate applied to your current card. If it doesn’t make sense, then don’t do it. This method is to be used for your benefit, not the creditors’.
If you do go with a balance transfer, do not forget why you’re doing it. There are countless stories of people increasing their overall debt balances because they convince themselves that their credit card balance is low which means they can continue spending like they were before.
This is a backwards way of thinking and you should ensure you don’t fall into this trap. As long as you’re on top of your spending, you should be fine. Also, there may be a time period until the new card kicks you into a higher interest rate. This usually happens around the 12-month mark so keep an eye out for that.
Make more money (or find it)
Find out what you’re passionate about and create a side income from it. You’d be surprised just how many options are out there that people will pay YOU money for.
If you’re a decent typer, be a transcriber for a podcast or content creator. If you value how well you detail your car, open up a mobile detailing service. If your room is cluttered with unused stuff, sell on eBay or Facebook marketplace.
There are countless ways that you make money. It just takes a little creativity on your part then you find the demand for it. It’s possible that it could become a big hit for you and your finances.
The next suggestion is to increase the “gap”. Coined by the popular group, “ChooseFI”, this simply means to increase the space or “gap” between your income and your expenses. An example is, if you earn $3,000 per month but you spend $2,600 per month, then your gap is $400. But if you make $2,500 per month and you spend $2,900 per month, then you have a negative gap of $400.
Having a negative gap puts you in the red every month. Your goal should be to always keep your gap in the green. If your gap is green, then you have more money than you’re spending which means you have extra cash to fund towards paying down debt. It’s very simple.
What is considered a high interest rate?
Determining what is considered “high” is subjective to who you ask and what that interest rate is applied to. For example, a family whose only debt is their mortgage will look at it differently than a family drowning in credit card, personal loan, line of credit, and mortgage debt.
With that same example, the family with multiple lines of debt can easily prioritize which interest rate is higher because they have more than one to choose from compared to the family with only one debt which is their mortgage.
But to answer the question, I’d say that anytime you’re paying over the median interest rate, that is considered high. So with interest rates ranging from 2% to as high as 26%, that puts the mid-range right about 14%. Anything over 14% is too much for my liking and I push to get rid of that debt immediately.
Again, this is relative to who you ask and what type of debts they currently have. It is important that you look at each of your debts separately rather than treating them equally. Most likely they are not the same so they shouldn’t be treated the same. They each have a purpose in your finances which is why you acquired them. But paying them off requires a different perspective.
Conclusion
In the end, paying off any debt, whether high or low interest, will be gratifying either way. But working hard to pay it off will seem longer when your bottom line shows you that while you paid off that lower interest rate loan, you were slowly leaking money out of your bank account all going towards the interest on the credit cards. If your goal is to apply more of your hard earned income efficiently, think about checking your financial picture and ditching the high interest debt first.
When was the last time you looked at the interest rates on your debts? How do you plan to grow your “gap”? What is your strategy to pay off your debt?