The Ultimate Guide to Figuring Out Which Debt to Pay First

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Want to improve your personal finances by paying off debt? Ask yourself these four questions to decide which debt to pay off first. 

Many people have multiple different kinds of debt to pay off. For example, you might have several credit cards that you owe money on. Or you might have a credit card, a personal loan, and a car payment that you want to get paid off for good.

If you have several kinds of debt to take care of, you’ll need to make a strategic choice about which to focus on repaying first. Answering these four questions will enable you to make your plan so you can develop a clear path toward the financial freedom that comes with being debt free.

1. How motivated am I to repay this debt?

Paying off debt can be hard work, so if you don’t stay motivated, you may give up doing things like making extra payments. There’s one approach to becoming debt free that’s designed to help you stay on track by giving you small wins. It was made popular by finance guru Dave Ramsey and it’s called the debt snowball method.

With this approach, you send extra payments to the debt with the smallest balance first so you can pay that one off in full and score a win so you’re more likely to stay on track. Then you pay extra on the debt with the next smallest balance, and so on, until you’re out of debt. This approach is backed by science, and researchers at Northwestern University’s Kellogg School of Management found it does work to keep people motivated and maximize their chances of success.

However, if your larger balances have higher interest rates, it would make mathematical sense to pay off those debts first so you can stop paying those bigger financing charges. The key is, you would need to find your own motivation to keep slogging away, especially if it takes you a very long time to actually eliminate the debt.

If you’re super excited about paying off what you owe and you don’t need the extra mental boost that comes from being able to erase a loan entirely from your balance sheet, then you should consider skipping the snowball approach and trying to get rid of those high-rate loans ASAP by paying extra on them first. (This is commonly called the debt avalanche method.)

2. Which debt has the highest interest rate?

As mentioned above, it’s important to pay attention to the interest rate on your loans when you’re repaying debt. If you have loans at a very high rate, it can make sense to get serious about paying them back right away.

Say, for example, you had the following debts:

A $1,000 balance at 4% APR you were paying $75 per month onA $5,000 balance at 9% APR you were paying $125 per month onA $9,000 balance at 25% APR you were paying $278 per month onA $12,000 balance at 18% APR you were paying $300 per month on

If you could pay a total of $1,000 a month to your debts (which total $27,000) and you paid off your loans in order of highest to lowest interest rate, you’d end up saving $1,862 in interest and would be out of debt two months sooner than if you instead opted for the debt snowball method.

The bigger the difference between your highest and lowest rate, the more you can save by focusing on paying your more expensive debts first. You can check your APRs by reading your card and loan statements to decide if you should go in order of high to low rates when trying to get a debt paid down.

3. Are there any prepayment penalties I need to worry about?

Sometimes, loans come with prepayment penalties. That would mean if you paid them off ahead of schedule, you would have to pay a fee to your lender. This fee is often a percentage of your loan balance.

If a debt has a prepayment penalty, paying it off early may not make as much sense since you won’t save as much. Check the fine print on your loan agreements to see if that’s the case.

4. Should the debt really be paid off early?

Finally, you’ll want to think about whether it really even makes sense to pay off a particular loan ahead of schedule. If the interest rate on the loan is below what you could earn by investing in something safe (like an S&P 500 fund that has consistently paid 10% average annual returns), then you may not want to make any extra payments on that loan at all. Mortgage loans are a good example of a type of debt considered “good debt,” and since even the higher mortgage rates of today are well under 10%, you’re likely ok continuing to repay your mortgage loan as scheduled.

By asking yourself these key questions, you can decide what debt payoff approach is right for you. Figure it out ASAP and start working on paying extra to at least some of your creditors so you can be done with your debt for good and improve your personal finances.

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