I hear that when paying down debt, the best way to do so is to pay down the highest interest debt first. Is this always the case? Does this rule apply regardless of the type of debt?
For example, should I throw an extra $100 toward an auto loan or mortgage if my credit card APR is lower?
Taxation might come into it. If you have a tax concession on a particular kind of loan (e.g., housing loans in the US), then you might pay of a loan at a lower interest rate that did not have a similar tax concession. Another factor might be penalties for paying off a loan too soon.
OK, let’s assume there are no pre-payment penalties or tax implications.
I’m not an accountant or financial planner, but I think you are better of paying the credit cards first. Auto and home loans have the interest figured out for the life of the loan. With credit cards you are paying interest on top of interest. Even if the rate is lower on a credit card, the payments can still add up to more. Especially if you are paying near the min. payment. Again, a financial planner could do all the math.
Another thing to consider though is if you can pay off a bill completely, you will free up money which can then be applied to another bill.
I’m not a financial whiz by any means, but my bro the CPA/CFO has said you should never pay off your mortgage if you’ve got other bills. Me, I’ve worked at getting rid of the higher rate bills, figuring to be making mortgage payments till I hit the lottery or die - whichever comes first.
IIRC, the usual recommendation is to pay down unsecured debt first, in order from highest to lowest interest rate if there’s more than one.
Well, one consideration is that using a large percentage of available credit can ding your credit report. So as far as credit cards are line of credit loans are concerned, you want to make sure all of them are ideally at less than 50% of credit limit. If I had some that were maxed out I would pay them down first, regardless of interest rate. Then when you’ve paid down the maxed or near-maxed ones, you can start paying higher interest ones first.
In theory it’s a good idea to pay secured debt first, because it’s secured by something (like your house or your car) that can be taken away if you default. Unsecured debt is not “secured” by such an obligation. In reality, it’s almost always a better idea to pay unsecured debt first because they are generally smaller debts that you can discharge fully in a few years, as opposed to an obligation you have to pay off over many years. I would probably put an extra 100 towards a credit card because I do use my credit cards and I try to keep the balances low.
Not an accountant here.
I would be very surprised if the mortgage wasn’t the lowest interest rate. If it isn’t, you may be able to refinance, or else you have some very attractive loan rates. The only thing that I could think of would be school loans, but I thought that even those rates are higher than a mortgage.
There may be another good reason to keep a mortgage over another loan. If you have enough mortgage interest, you can deduct that from your income by itemizing deductions. That opens the door to piling on other deductions (such as charitable contributions, taxes, business expenses etc.) that by themselves may not have been enough to allow you to itemize.
I don’t know whether any other interest payments are deductible, but if not, yeah - I would start with the highest rates and pay them off first. J D Rockefeller called compound interest the Eighth Wonder of the World. In that case, he was talking about investing, where a higher interest rate reaps much higher rewards down the road. The reverse is true; the higher the rate that you are paying, the loan will cost much more down the road.
Can you shop for the lowest rate, and then transfer all your higher rates into that loan?
What if you have a large balance at a lower interest rate and a small balance at a high interest rate? If I get some extra money beyond my regular monthly payment, which one of those should I toss extra cash to first, assuming they’re both credit cards? Assume a $10,000 balance at 7% and a $2,000 balance at 24% - and there’s no room on the lower interest rate card for a balance transfer.
(These are the kind of word problems we should be using in elementary school, people!)
If you have high interest rates (+10%) or extremely high interest rates (+20%), pay them off first as quickly as you can. And, of course, quit charging to them.
Secondly tackle auto loans and/or home equity loans.
Consolidation loans are great if you can get a lower interest rate. Home Equity Lines of Credit usually have attractive rates (1 or 2% above prime) but prime has so high lately that they’re not so great. Of course, you can sometimes deduct interest on your taxes from HELOC, which is something to consider.
First you pay down the balances to between 33% and 50% on all of them. If you don’t have room for a balance transfer of 2K on a card that already has a balance of 10K, you’re using too much available credit on that card. So you pay down that one first until your “use of credit” for the card is better – between 33% and 50%. Then, with a lower balance, and assuming in the meantime you’re making minimum payments on the 2K, you should be able to tranfer the balance of the 2K to the formerly 10K card and pay it down.
Thank you, this makes sense and is very useful. As I’m sure you guessed despite my cunning, this isn’t entirely hypothetical for us!
Yep, we maxed out on just about everything to pay hospital bills for the preemie. Our interest rates on everything were pretty good, and we’ve never late, but then the companies noticed that we were actually using more of our credit than they liked so they raised the rates on us. Fucking bullshit, I say - if they give you a credit amount at a specific interest rate, how the hell is it justifiable to raise the interest rate if you come too close to using the amount of credit they authorized? (Not to mention that “They” won’t tell us what “too large a percentage” is.) :rolleyes:
In addition to mortgage and student loans, the wife and I have…
My Credit Card: About $10,000 at 3% APR fixed for the life of the debt (wedding, honeymoon, and stuff for new home); credit limit is $11,000
Her Auto Loan: About $6,000 at 13% APR
That’s why I’ve made the point a couple of times, because the exact thing happened to me. When I went to buy my house, I learned that my credit score had been lowered slightly because I was using too high a percentage of my available credit. Hell, I didn’t even know they cared how much credit you were using, so long as you didn’t go over. I could have easily been using my credit cards less if I’d been aware that was an issue, and I promptly (well, as promptly as I could) paid them down. I didn’t close them, because paradoxically open unused credit is a good thing. Whatthefuckever.
Psychologically it may be better to pay off the lowest balance loan first. The thinking behind this is you see real progress once you pay off that loan, and now you have more money to attack the second highest debt, so that one seems to fall fast too.
I never knew this! We never max out our cards, but now I have another reason not to!
Any thoughts on this one? Same thing as what Jodi said?
Yep, it doesn’t make sense mathematically, but money is more than just numbers - there is a huge emotional component. A lot of people have success with this method.
If your main goal is to pay down the debt as fast as possible (and thus pay the least amount of total interest), pay the auto loan off first. However, you have to make sure not to use the credit card with the $10,000 on it, as any new purchases will sit there at a high APR until the $10,000 is completely paid off.
Another reason that you may wish to pay down the lowest balance first is that it will give you one less payment to possibly forget. Credit card companies are quite nasty with late payment fees and can also drastically increase the interest rate with one payment late by one day.