nortonrsx | iStock | Getty Images
Not all debts are created equal. So how should you decide what to repay first?
Amid last year’s coronavirus pandemic and the economic recession that followed, many Americans’ debts grew. In 2020, consumer debt soared to a new high of $ 14.88 trillion, up 6% year over year, according to ratings firm Experian.
Today, according to Experian data, the average American owes more than $ 92,000 in debt. That sum includes many different types of debt, including credit cards, student loans, mortgages, and more.
More from Invest in You:
Almost half of Americans take on debt as post-pandemic treatment
How to resist the urge to splurge on a post-pandemic shopping spree
In this way you avoid spending too much in this hot housing market
As the US moves out of the pandemic and Americans return to a new normal, some may be trying to actively settle the bills accrued over the past year.
This is how you determine which debts should be paid back first.
Find a hierarchy of debt
Before deciding on a repayment strategy, experts recommend determining which debts are hurting you the most. That way, you can work on paying them first to improve your financial standing.
“It’s important to differentiate and understand this and focus on the most damaging debts that really hurt you first,” said Chris Lyman, certified financial planner with Allied Financial Services in Newtown, Pennsylvania.
For its own customers, Lyman likes to divide the debt into three “zones” – red, yellow and green.
Debt in the Red Zone, typically with the highest interest rates, is the most damaging. This includes things like credit cards, personal loans, and some personal student loans. For example, the interest on a credit card can be as high as 30% and even top up daily, which means that it can quickly go up even further if it is not paid off.
Yellow zone debts have lower interest rates, are generally longer-term, and may have some tax benefits, such as: Lyman would also include auto loans in this category because a lot of people choose to wear them rather than paying off cars in full.
Green-one debt is the longest term with the lowest interest rates, according to Lyman, and anything that will help you build an asset. These include mortgages – interest rates can go up to 2% – as well as some corporate loans.
“It doesn’t just bother you,” said Lyman. “Some kind of balancing asset is being built.”
It’s like a drowning feeling when it comes to consumer debt, the interest rates are so high.
Chris Lyman
certified financial planner at Allied Financial Services
According to Delano Saporu, CEO of New Street Advisors Group, a financial planning and portfolio management firm based in New York, you can also think about what debt is the most weighing on you. This is often consumer debt from credit cards, which is the best place to start, he said.
“It’s like a drowning feeling when it comes to consumer debt, the interest is so high,” he said. “You bought things that you didn’t really need, that you just wanted, and so it leaves a feeling of despair.”
Given the pandemic, some may also be dealing with other types of debt that are not necessarily interest rate related but could have a huge impact on their lives, such as months of rent. These are also debts that should be a top priority, according to Saporu.
Avalanche vs. Snowball
Once you have categorized your debts and know what to focus on first – while making minimum payments on all other debts, of course – you need to decide on a repayment strategy.
Before you begin dedicating any part of your budget to paying off debt, financial experts recommend building at least a small emergency savings fund. The reason? Without a pillow, an emergency or even an unexpected life event – like an illness or a car breakdown – could throw you even more down the drain.
Once you have an emergency saving, there are two common repayment strategies that financial experts recommend – the avalanche method and the snowball method.
With the avalanche method, you first pay off the debt with the highest interest rate, then switch to the next higher interest rate, and so on. Over time, those who choose this method will pay less interest by turning off the high-yielding ones first.
This is recommended for people who are disciplined and able to stay the course, Lyman said. The highest interest rate debts may not be the smallest, and so using this method can seem like a marathon rather than a sprint.
The snowball method is better for people who are seeing rapid progress, celebrating small wins, and want to use that momentum to tackle larger debts. In this method, you start with the smallest balance first.
“Mentally, taking debt to zero makes people feel good,” said Saporu. “Especially when you’re younger and you’re building your cash flow, building your income, this is a great way to gradually start feeling better.”
As you move forward in your career and income, you can tackle larger debts, according to Saporu.
SIGN IN: Money 101 is an 8-week financial freedom learning course delivered to your inbox weekly.
CHECK OUT: How to make money doing creative sideline activities, from people who make thousands on sites like Etsy and Twitch over Grow with acorns + CNBC.
Disclosure: NBCUniversal and Comcast Ventures are investors in Acorns.
Comments are closed.