SAN JOSE, Calif.–(BUSINESS WIRE)–Paying off a debt usually makes good financial sense. Still, you might be able to add a little strategy to your debt elimination journey and turn a good plan into a great one.
Depending on your credit obligations, paying off some debts before others could provide a number of benefits. When you pay off your debts in the right order, you can save more money in interest charges, get out of debt faster, or see your FICO® scores improve.
However, when it comes to the best way to pay off debt, you will find that there is more than one approach to consider. Even financial experts sometimes disagree on what types of debt consumers should pay off first. Here are some educational tips on how to determine the best debt elimination approach for your specific situation, from myFICO.
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Revolving or installment debt
Most credit obligations fall into one of two categories: revolving or installment. Understanding the difference between these types of accounts is essential when trying to decide which debts to pay off first.
- Payout accounts are loans such as mortgages, personal loans, car loans, etc. With installment loans, you borrow a fixed amount. Then you repay those funds at a fixed amount each month until you repay the borrowed money plus the 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 you can borrow from the account at any given time. But as you repay the borrowed funds, you may be able to borrow again, up to the account’s credit limit. Credit cards and lines of credit are two common examples of revolving credit.
In many cases, it’s best to focus on paying off your revolving account balances first. Credit cards, in particular, often have higher interest rates than other types of credit. Additionally, your FICO® scores could benefit when you pay off your revolving credit card balances, as it could lower your credit utilization rate.
First option: focus on the interest rate
Higher interest rates can increase the cost of borrowing money. In order to avoid some of these expenses, some people prefer to tackle high-interest credit obligations first when they begin to pay down their debts.
With this method of paying off debts, commonly known as debt avalanche, you start by listing the debts according to the interest rates on those accounts. The account on which you pay the highest interest rate is at the top of your list. From there, you list the remaining debts in descending order. Some consumers may also decide to take this strategy one step further and focus on credit card debt first.
Here is an example of how you might list your credit obligations if you are using the debt avalanche payment 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’ve created your list of debts, be sure to make the minimum payment on each account to avoid late payments and other issues. Then you use all the extra money you can find in your monthly budget to pay off the account with the highest interest rate.
Eventually, the balance of the first account on your list will reach zero. At this point, you move on to the next debt on your list and start the process again.
Option two: Focus on balance
Another way to pay off your debts is to focus on how much you owe each creditor. This approach, often called the debt snowball, also starts with a list of your debts. However, the debts on your list appear in a different order, from lowest balance to highest.
Below is an example of what your debt repayment list might look like using the snowball debt repayment method.
Credit card #1: balance of $500, annual interest rate of 16.9%
Credit card #2: $2,500 balance, 18.9% APR
Credit card #3: $5,000 balance, 17.9% APR
As before, you start by paying off the first debt on your list as aggressively as possible. You will apply any additional funds you can create by reducing expenses or earning additional income to the account with the lowest balance.
In the meantime, you continue to make at least the minimum payment on all other credit obligations. Once you’ve paid off the debt with the lowest balance, you move on to the next account on your list and repeat.
How to Choose the Best Debt Repayment Approach
There really isn’t a “wrong” way to pay off debt. Yet each of the above debt repayment strategies has different benefits.
With the avalanche of debt, you could save more money in interest, at least initially. Working to zero account balances as quickly as possible with the debt snowball, by comparison, could be good for your FICO® scores. Plus, if you achieve a higher FICO score, it could open the door to other benefits like better interest rates on future loans.
Determining the best credit obligation to pay off first will largely depend on your goals. So you might want to take a moment to ask yourself a few questions.
Are you more concerned about paying less interest? If so, you might want to focus on paying off your credit card balances with the highest interest rates first. Those planning to apply for new financing in the near future might prefer to pay off their cards with the lowest balances first in order to see potential FICO® score improvement.
myFICO makes it easy to understand your credit with FICO® Scores, credit reports and alerts from all 3 bureaus. myFICO is the consumer division of FICO – get your FICO scores from the people who do FICO scores. For more information, visit https://www.myfico.com/credit-education