Is there a right or wrong way to pay down your debt? The answer is not cut and dry; it depends on your financial and personal goals and objectives. There are two main theories about the order of which to pay off loans, and even more advice about those plans.
Pay down the loan with the highest interest rate first
The first school of thought is to pay off debts by interest rate from highest to lowest. The theory behind this is that it will save you the most money in the long run. This plan does make sense, as debt with high interest is costing you more money over time. The problem with this strategy is this: You may physically have more traction over our finances, but you won’t feel like you do. Full disclosure — if your highest interest loan is also your largest debt, it will take a while to pay it off. You will not feel like you’re making any progress; thus it may make it difficult to stay focused on paying off debt without the satisfaction of knowing a debt is paid in full.
Pay down smaller debts first
If you’re into immediate gratification, this is the plan for you.
“You can clear up a lot of smaller monthly payments and quickly apply those to the extra money you are paying off on your debt snowball,” explained money management expert Miriam Caldwell of the Money in Your 20s website.
The downside here is that you could lose important tax benefits of having big loans paid down and you could end up paying a lot more interest in the end (see above) by putting high interest loans last in your order of importance.
Take a balanced approach
Knock out a few of your small loans in a few months and then work on larger interest debt before going back to paying on small loans again. Another way to balance out your methodology is to pay smaller loans off more quickly if the interest rates are generally within a percentage point or two, because that will give you more power to pay off the larger loans.
“You may want to put the loans that save you on your taxes at the end of your debt payment plan. This would be your student loan, home equity loan or second mortgage,” added Caldwell. “These debts may also have lower interest rates. This lets you continue to deduct the interest from your taxes each year.” Obviously do not hold onto debt simply for tax purposes, she included.
Stick to the plan
Eventually, minimum payments may start to go down on debts like credit cards. Tempting as it may be to use the extra money that you once had to put toward loan payments on frivolous personal items, resist the urge. Use that extra money as an additional payment on your loans, using the same plan you started with initially to designate importance. This will help cut your debt down even more. However, Caldwell inserted that you don’t have to stick to the exact same plan forever.
“As the terms of your loans change or your current situation changes, you can make adjustments to the order of your debt payment plan,” Caldwell said. “But you do need to keep paying extra each month.”
It may be hard to stay motivated, but there are ways to successfully pay off your debt. Create a chart where you can visually track your progress, or celebrate milestones along the way of your debt-repayment journey. Keep in mind that with a solid plan, debt will not last forever.
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