Here’s how to decide which debt you need to pay off first
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Not all debts are the same. So how should you decide which one to pay off first?
Amid the coronavirus pandemic last year and the economic recession that followed, debt has risen for many Americans. In 2020, consumer debt hit a new high of $ 14.88 billion, a 6% increase from the previous year, according to rating firm Experian.
Today, the average American has more than $ 92,000 in debt, according to data from Experian. This total includes many types of debt, including credit cards, student loans, mortgages, and more.
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As the United States emerges from the coronavirus pandemic and Americans begin to return to a new normal, some may seek to actively pay off the bills they have racked up over the past year.
Here’s how to determine which debts need to be paid off first.
Find a debt hierarchy
Before deciding on a repayment strategy, experts recommend determining which debt hurts you the most. That way you can work on paying it off first to improve your financial situation.
“It’s important to differentiate that and to know that and to focus on what really is the most damaging debt early on,” said Chris Lyman, certified financial planner at Allied Financial Services in Newton, PA.
For his own clients, Lyman likes to divide the debt into three “zones”: red, yellow and green.
The red zone debt, usually with the highest interest rates, is the most damaging. This includes items such as credit cards, personal loans, and some private student loans. Interest rates on a credit card, for example, can be as high as 30% and can even be compounded daily, meaning they can quickly rise even more if not paid off.
Debt in the yellow zone has lower interest rates, is generally longer term, and may have some tax advantages, such as a home equity line of credit, federal student loans, both of which are deductible. Lyman would also include auto loans in this category, as many people decide to carry them instead of paying off the cars in full.
According to Lyman, green zone debt is longer-term debt with the lowest interest rates and anything that helps you build an asset. This includes mortgages – rates can be as low as 2% – as well as some business loans.
“It’s not just weighing you down,” Lyman said. “There is some sort of compensation asset being built.”
According to Delano Saporu, CEO of New Street Advisors Group, a New York-based financial planning and portfolio management firm, another way to prioritize debts to pay off is to think about which ones weigh the most on you. Often it’s consumer debt from credit cards, which makes it the best place to start, he said.
“It’s like a drowning feeling when it comes to consumer debt, the interest rates are so high,” he said. “You bought things that you didn’t really need, you just wanted, and that leaves a feeling of hopelessness.”
Given the pandemic, some may also be faced with other types of debt that don’t necessarily come with interest rates but could have a big impact on their lives, such as owing months of rent. . It is also debt that should be a top priority, according to Saporu.
Avalanche against snowball
Once you’ve categorized your debts and know what you want to focus on in the first place, while making minimum payments on all other debts, of course, then you need to decide on a repayment strategy.
Before you start allocating a portion of your budget to pay down debt, financial experts recommend that people set up at least a small emergency savings fund. The reason? Without a cushion, any emergency or even unexpected life event, like an illness or car breakdown, could put you in even more trouble.
Once you have emergency savings, there are two common repayment strategies that financial experts recommend: the avalanche method and the snowball method.
With the avalanche method, you pay off the debt with the highest interest rate first, then move on to the next highest interest rate, and so on. Over time, those who choose this method will pay less interest by eliminating high interest ones first.
This is recommended for people who are disciplined and able to stay the course, Lyman said. The highest interest rate debt might not be the smallest balance owed, so using this method can feel like a marathon instead of a sprint.
The Snowball Method is best for people who want to see quick progress, celebrate small wins, and use that momentum to tackle bigger debt. In this method, you start with the smallest balance first.
“Mentally, reducing debt to zero makes people feel good,” Saporu said. “Especially if you’re younger and increasing your cash flow, your income, it’s a great way to gradually feel better.”
As you advance in your career and income, you may face larger debts, according to Saporu.
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