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Not all debts are the same. So how should you decide which one to pay off first?
Amid the coronavirus pandemic last year and the economic recession that followed, many Americans’ debts grew. In 2020, consumer debt ballooned to a new high of $14.88 trillion, up 6% from the previous year, according to credit rating company Experian.
Today, the average American has more than $92,000 in debt, according to Experian data. This total includes many different types of debt, including credit cards, student loans, mortgages, and more.
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With the United States emerging from the pandemic and Americans beginning to return to a new normal, some may be looking forward to paying the bills they owed last year.
Here’s how to decide which debt to pay off first.
Find the debt hierarchy
Before deciding on a repayment strategy, experts recommend identifying the debt that harms you the most. This way, you can work on paying that amount first to improve your financial situation.
“It’s important to differentiate between that and know that and focus on what is really the most damaging debt initially,” said Chris Lyman, a certified financial planner with Allied Financial Services in Newtown, Pennsylvania.
For his clients, Lehman likes to divide the debt into three “zones” – red, yellow and green.
Red zone debt, usually with the highest interest rates, is the most damaging. This includes things like credit cards, personal loans, and some private student loans. For example, credit card interest rates can be as high as 30% and may accrue daily, which means they can grow more quickly if they are not repaid.
Yellow-zone debt has low interest rates, is generally long-term and may have some tax advantages, such as a home equity line of credit and federal student loans, both of which have some deductible power. Lehman will also include auto loans in this category, because many people decide to take on them rather than pay off the cars in full.
Green—The one debt that has the longest tenure with the lowest interest rates, and anything that helps you build an asset, according to Lehman. This includes mortgages – interest rates can be as high as 2% – as well as some business loans.
“It just doesn’t weigh you down,” Lyman said. “There is some kind of compensatory asset being built.”
Another way to think about prioritizing debt that needs to be repaid is to think about the ones that weigh you down the most, according to Delano Sapporo, CEO of New Street Advisors Group, a financial planning and portfolio management firm in New York. This is often consumer credit card debt, he said, making this the best place to start.
“It’s like feeling overwhelmed when it comes to consumer debt, interest rates are way too high,” he said. “I bought things that I didn’t really need, I just wanted, and that leaves a sense of despondency.”
Given the pandemic, some may also be dealing with other types of debt that don’t necessarily come with interest rates but can have a major impact on their lives, such as coming due months of rent. According to Sapporo, this is also a religion that should be his top priority.
Avalanche vs Snowball
Once you classify your debts and know what you want to focus on first — while making minimal payments on all other debts, of course — you then need to decide on a repayment strategy.
Before you start allocating a portion of your budget to paying off debt, financial experts recommend that people set up at least a small emergency provident fund. Reason? Without a pillow, an emergency or even an unexpected life event — like an illness or a car breakdown — can put you even more in the hole.
Once you have emergency savings, there are two popular repayment strategies that financial experts recommend – the avalanche method and the snowball method.
With the avalanche method, you pay off the debt with the highest interest rate first, then move to the next highest interest rate and so on. Over time, those who choose this method will pay less interest by eliminating those with higher interest first.
This is recommended for people who are disciplined and can carry on with the course, Lyman said. The highest interest rate debt may not be the smallest debit balance, so using this method can feel like a marathon rather than a sprint.
The snowball method is best for people who want to see progress quickly, celebrate small gains, and use that momentum to tackle larger debts. In this method, you start with the smallest balance first.
“Mentally, making some debts go to zero makes people feel good,” Sapporo said. “Especially if you’re younger and increasing your cash flow, increasing your income, this is a great way to gradually feel better.”
According to Sapporo, the more you advance in your career and income, the more debt you can tackle.
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