Paying down debt is generally wise from a financial perspective. Yet you may be able to add a bit of strategy to your debt elimination journey and turn a good plan into a great one.
Depending on your credit obligations, paying off certain debts before others might offer a number of benefits. When you pay down debts in the right order you might save more money in interest fees, get out of debt faster, or potentially see your FICO® Scores improve.
However, when it comes to the best way to pay off debt, you'll find that there's more than one approach to consider. Even financial experts sometimes disagree about which types of debts consumers should pay off first. Here are some educational tips on how to figure out the best debt elimination approach for your specific situation, from myFICO.
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Revolving vs. Installment Debt
Most credit obligations will fall into one of two categories—revolving or installment. Understanding the difference between these types of accounts is essential when you're trying to decide which debts to pay off first.
- Installment accounts are loans like mortgages, personal loans, auto loans, and more. With installment loans you borrow a fixed amount of money. Then, you repay those funds at a fixed amount each month until you pay back the money you borrow plus any interest and fees you agreed to pay the lender.
- Revolving accounts come with a credit limit. When the lender sets your credit limit, it represents the maximum amount of money you can borrow on the account at a given time. But as you repay the funds you borrow you may be able to borrow again—up to the credit limit on the account. Credit cards and lines of credit are two common examples of revolving credit.
In many cases, it's best to focus on paying down the balances on your revolving accounts first. Credit cards in particular often have higher interest rates compared with other types of credit. Furthermore, your FICO® Scores might benefit when you pay down your revolving credit card balances since doing so may reduce your credit utilization ratio.
Option One: Focus on the Interest Rate
Higher interest rates can increase the cost of borrowing money. In an effort to avoid some of that expense, some people prefer to tackle high-interest credit obligations first when they start paying down debt.
With this method of paying off debts, commonly known as the debt avalanche, you begin by listing out the debts according to the interest rates on those accounts. The account on which you pay the highest interest rate goes at the top of your list. From there, you list remaining debts in descending order. Some consumers may also decide to take this strategy a step farther and focus on credit card debt first.
Here's an example of how you might list out your credit obligations if you're using the debt avalanche payoff method.
- Credit Card #1: 18.9% APR, $2,500 Balance
- Credit Card #2: 17.9% APR, $5,000 Balance
- Credit Card #3: 16.9% APR, $500 Balance
Once you create your list of debts, be sure to make the minimum payment on every account in order to avoid late payments and other issues. Then, you use all of the extra money you can find in your monthly budget to pay down the account with the highest interest rate.
Eventually, the balance on the first account on your list will reach zero. At that point, you move down to the next debt on your list and restart the process.
Option Two: Focus on the Balance
Another way to pay down your debts is to focus on how much money you owe to each creditor. This approach, often called the debt snowball, also begins with a list of your debts. However, the debts on your list appear in a different order—from the smallest balance to the highest.
Below is an example of what your debt payoff list might look like using the debt snowball payoff method.
- Credit Card #1: $500 Balance, 16.9% APR
- Credit Card #2: $2,500 Balance, 18.9% APR
- Credit Card #3: $5,000 Balance, 17.9% APR
As before, you begin by paying off the first debt on your list as aggressively as possible. You would apply any extra funds you can create by either cutting expenses or earning extra income toward the account with the lowest balance.
In the meantime, you continue to make at least the minimum payment on every other credit obligation. Once you pay off the debt with the lowest balance, you move to the next account on your list and repeat.
How to Choose the Best Debt Payoff Approach
There's not really a "bad" way to pay off debt. Yet each of the debt payoff strategies above have different benefits.
With the debt avalanche, you might save more money in interest, at least initially. Working to zero out the balances on accounts as quickly as possible with the debt snowball, by comparison, might benefit your FICO® Scores. Plus, if you do achieve a higher FICO Score, it might open the door to other perks such as better interest rates on future loans.
Figuring out the best credit obligation to pay off first will depend in large part on your goals. So, you may want to take about moment to ask yourself some questions.
Are you most concerned with paying less interest? If so, you might want to focus on paying down your credit card balances with the highest interest rates first. Those who plan to apply for new financing in the near future might prefer to pay off their cards with the lowest balances first in an effort to see potential FICO® Score improvement.
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