There is all kinds of advice floating around as to which debts you should pay off first. Most advisors seem to have a preference for paying off credit cards or mortgages ahead of other types of debt.
There may be no right and wrong when it comes to paying off debt – after all, paying off just about any debt is a step in the right direction. But some debts are more threatening than others, so we’re going to look at paying off debts in the order of most risky to least risky. When you look at it that way, the whole order changes.
1. Car loans
I am a strong advocate of paying off car loans ahead of any other type of debt. There are two primary reasons for this:
High monthly payment to balance. If you owe $10,000 on a credit card, your monthly payment is probably around $200. On a student loan debt, it’s probably a little bit over $100. With a car loan, the monthly payment could easily be $400. That is a big, fat monthly payment, and getting rid of it as soon as possible will do wonders to improve your cash flow, and make it easier for you to concentrate on paying off other debts. Typically, paying off a car loan gives you the greatest bang for the buck when it comes to improving your budget. This is why it needs to be the first loan that you pay off.
The outcome if you are unable to pay this debt. This is an issue most people don’t think much about, but you need to. Typically, a car is an asset that you use in the production of income. Whether you use your car for business purposes or to commute to your job, you need your car in order to earn a living. If you lost your job and could no longer afford to make the payments on your car, the car would be repossessed and you would be unable to get a new job for lack of a way to get there. For this reason alone, paying off your car loan should get top priority.
2. Business loans
There are a large number of people who are self-employed in small businesses and have certain assets that are required in order for them to generate income. Paying off debts associated with these assets is a close second to paying off car loans.
The case here is similar to giving a priority to paying off your car loan. An asset used in the production of income should be owned free and clear, that way if you hit on hard times and couldn’t afford to make your debt payments, you will still be able to earn a living.
3. Other secured loans
If you have a secured loan that is collateralized by an important asset, you should pay it off as soon as possible. This may not be a true priority if the loan is secured by furniture or a recreational vehicle, since they are not necessities. But if the loan is attached to something you can’t live without, it should be given a priority. This is because normal functioning in your household will not be possible in the event that a major asset is repossessed.
4. Credit cards – smallest to largest
Most financial advisors make paying off credit cards the number one priority. But in the grand scheme of things, credit cards are more of an annoyance than anything else. If you fall behind, the creditors can harass you and threaten you with of all kinds cataclysms, but they won’t be able to remove important major assets from your life. You’ll still be able to get to work every day, to heat your house and to do your laundry, you’ll just have to get used to living under a constant cloud of threats.
The two most compelling reasons to payoff credit cards are:
- High interest rates, and
- The rates are variable
These are legitimate concerns, but in the current low interest rate environment, you have time to payoff the more dangerous loans listed above before taking on any of your credit cards. And if you do, you’ll have more cash to payoff your credit cards.
5. Student loans
These days it seems that nearly anyone who has a student loan wants to pay it off. That makes sense, given the long-term nature of the debt. But at the end of the day, student loan debts are simply not that threatening. Monthly payments are low compared to the outstanding balance, and interest rates are far more well behaved than your credit cards. In short, student loans aren’t going anywhere so you have plenty of time to take care of other debts first.
Given the fact that student loan debts are typically large balances, you’ll probably need to payoff other debts before taking on these. In order to make substantial progress in paying off a large balance, you’ll have to clear the decks of other obligations to free up your cash flow to make the larger payments. Which is another compelling reason to pay off other debts ahead of your student loans.
6. Your Mortgage
Next to credit cards, paying off the mortgage is probably the most recommended course of action. But there are a whole lot of reasons to hold this debt until last:
- The loan is secured by your home, which probably has enough equity that you can sell it to payoff the loan, if push came to shove.
- If you have negative equity in the house, the lender would be in no hurry to foreclose on you anyway, giving you time to work out some sort of settlement.
- Mortgages typically carry lower rates of interest than other types of debt.
- You’re probably getting some kind of income tax break on mortgage interest.
- If it’s a fixed rate mortgage, your payment cannot increase.
- A mortgage is long-term debt, which means you have close to forever to pay it off; in the meantime, you have the benefit of living in the house.
Perhaps the biggest reason of all to put mortgages at the back of the payoff line is their sheer size. Let’s say that you are three years into a 30 year mortgage, and still owe $250,000 on it. Even if you concentrate all of your efforts on paying off the mortgage, it will probably still taking years to do it.
And if it will take years, you’ll need to have all of your other debts paid off first, that way you’ll have the money that you need to make a serious effort to make your mortgage go away.
