If you have debts, it is a reasonable question to ask. What debt do I try and tackle first?
There are a few approaches to paying off debts.
Some of the approaches below will have you paying off your debts sooner, while others focus more on trying to get a healthy credit score. The method you use will depend on your personal circumstances.
It is probably easiest to explain using an example.
Joe Bloggs here has 2 credit cards, a car loan and a mortgage.
That is £14,000 of unnecessary debt but is sadly quite typical as people try and “compete with the Joneses”.
So let’s see how Joe might tackle his debt.
In a lot of cases, you won’t have a choice in how little you pay each month. This will likely be the case for the car loan and the mortgage.
For the credit card however, you have the ability to only pay the minimum on one of them while you pay down the debt of the others.
For these examples, I am going to make a number of assumptions just to make the math a bit easier to understand:
In addition to the £905.65 going towards the car loan and mortgage, for this example I am going to assume you have an additional £300 that can go towards your other debts.
In this example we are going to order the debts based on the interest rate and pay off the one with the highest first. This should mean you pay the least amount of interest and therefore save yourself money in the long run.
As each debt is paid off, the money then goes to the next debt with the next highest interest.
To start, we are paying £250 towards Debt 1, £50 towards Debt 2 and then the compulsory £203.65 to Debt 3 and £702.00 to Debt 4.
That is a total £1,204.65 each month going towards debt repayments.
After each Debt is paid off the remaining money goes towards the next highest interest debt.
In this example:
Total paid £242,003.95 from the original total loan of £204,000.00.
In this example, we are going to tackle the smallest debt first.
So we have money available towards paying off the next debt.
In this example:
Total paid £242,141.10 from the original total loan of £204,000.00.
So mathematically it does cost slightly more paying it off in this order but not by much and it gets rid of the small loan quicker.
The first 2 methods are the standard way of paying off debt. However, not all debt is considered equal. For example the debt owed on your mortgage is offset by the value of your house.
If you don’t already own a house then to get a mortgage you are going to want to try and increase your credit score. One way to do that is to increase the amount of credit available to you.
Debt 1 is £1,000 on a £5,000 limit, giving you £4,000 available credit. Debt 2 however, has £12,000 of available credit.
The car loan is a £10,000 loan on a car that may only be worth £8,000 now whereas your house might be worth £250,000 with the loan at £190,000.
In this case it would make more sense to focus on the car loan first and then tackle your lower limit credit card to increase the amount of credit available to you thus increasing your credit score.
Which method you choose will be based on your individual circumstances. It is important to work out yourself what the best order is to pay off your debts.
I would recommend paying off by balance first so you can minimise the number of debts you have.
Of course, there are other options available such as balance transfers that I haven’t mentioned in this post that could help a lot to reduce the amount of interest you end up paying.
You also need to keep an eye on early repayment charges especially on loans and mortgages. In some cases, you may not be able to pay off more than 10% of the balance per year or end up facing a hefty penalty.
In general you will want to get rid of your credit card debt first followed by any non-mortgage loans you have.
Once these are paid off, putting extra towards the mortgage is optional.
If you are following the financial independence plan paying off the mortgage isn’t until Level 9.
Alex started Pursuit of FIRE in 2019 to try and help people reach financial independence. He has spent nearly a decade working as a software developer in the finance industry and now is looking towards early retirement so he can spend more time with his young family.