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Deciding which loan to pay off first is subjective, but here’s what you need to know.
Over our lifetimes, we make a lot of expensive purchases — many that we can’t afford without taking out a loan. Student loans for paying college tuition. Mortgages for buying a house. Auto loans to secure a brand new car. Even general lifestyle expenses can add up quickly on a credit card.
Combine each of these loan types and you’ve got a hefty outstanding balance. According to Experian, the average U.S. consumer’s total debt was $92,727 in 2020. This leads to a common, yet tricky question: Which loans should I pay off first?
How are you supposed to choose between a student loan and a car loan? Or a car loan and a credit card?
To help you figure it out, we compiled a guide to the various types of loans and how you can prioritize repaying them.
Since loans come in different shapes and sizes, repaying debt isn’t a black and white process. There are a lot of moving pieces. So, to give you a better idea of your debt situation, we’ve outlined important loan factors.
There are many ways to borrow money — student loans, auto loans, mortgages, credit cards, and so on. We can lump these loans into two general types: installment loans and revolving credit.
Installment loans are divided into equal monthly payments over a predetermined period (known as a loan term). Student loans, auto loans, and mortgages are common examples of installment loans. For instance, when you take out a car loan, you receive a lump sum from your lender to buy a car, which you then repay in equal installments.
Unlike installment loans, revolving credit doesn’t provide you a one-time lump sum. Instead, you have a capped line of credit that you can draw down, repay, and draw again. Credit cards are the most common example. There isn’t a set repayment period; instead, your minimum monthly payments are based on a percentage of your outstanding balance. Home equity lines of credit (HELOC) fall under this category too.
Your loan’s term is the duration of the loan. For example, if you have an auto loan with a three-year loan term, that means your loan — including principal and total interest — is due in three years. This factor is important because it gives you an idea of urgency.
Let’s assume you have a personal loan due next year and a student loan due in 10 years. It would be wiser to prioritize repaying the personal loan since you have less time until your maturity date.
Your interest rate ultimately dictates how much you’re paying in addition to the initial loan balance, so it’s a major factor to consider. Remember how loans come in all sorts of shapes and sizes? Well, interest rates vary significantly depending on the type of loan.
Credit cards and personal loans tend to have higher interest rates. For example, the average credit card’s interest rate was 14.71% in 2020. In comparison, the average auto loan’s interest rate was around 5%, according to the Federal Reserve.
Now that you understand major debt factors, it’s time to categorize each of your loans.
Do you have good debt or bad debt — or both? Some loans are not only easier to manage but also offer a better return on investment.
Generally, there are three types of debt that can be considered “good” debt: student loans, mortgages, and auto loans.
These “good” loans enable you to buy something worthwhile that you couldn’t afford otherwise.
Student loans allow you to receive an education, which can open doors to better career opportunities. Real estate is expensive, and the average person can’t afford to buy a new house with just cash — but a mortgage makes this purchase possible. Auto loans function the same way. Each of these loans ultimately finances a worthwhile asset.
Although it depends on the borrower’s financial profile and lender, these loan types typically have lower interest rates too. The average credit card’s interest rate was nearly three times more than the typical auto loan last year. As you can imagine, a lower interest rate is an indicator of good debt.
Lastly, good debt often has other benefits too. Federal student loan programs offer loan deferment, forbearance, and even forgiveness. Mortgage interest and student loan interest are often tax-deductible too.
Bad debt doesn’t offer the same advantages.
Good debt enables people to buy valuable and functional assets (houses, cars, education, etc.). On the other hand, bad debt is typically more expensive and used unwisely.
The two most common types of bad debt are credit cards and personal loans. These forms of debt tend to have higher interest rates, and they’re much broader in scope. In other words, you can use a credit card to buy almost anything, while a mortgage’s proceeds are specifically used for buying property.
If you have poor spending habits, you may rack up credit card debt buying discretionary items like clothes, food, and expensive trips. If you don’t continuously pay off your credit card balances, your interest will accrue quickly.
And you’ll dig yourself into a financial hole.
Keep in mind that credit cards and personal loans aren’t inherently bad — and student loans, mortgages, and auto loans aren’t automatically good. Loans are subjective. For instance, a subprime auto loan may have a high interest rate. Not to mention unfavorable terms like prepayment penalties.
Conversely, a credit card can help you build credit and earn rewards like cashback and miles. And personal loans can also be used to consolidate debt at a lower interest rate, depending on your financial profile and issuer. Ultimately, it boils down to how much your debt costs you and how responsible you are with the proceeds.
With your debt categorized, you can more easily create a debt repayment strategy.
Keep in mind that credit cards and personal loans aren’t inherently bad — and student loans, mortgages, and auto loans aren’t automatically good. Loans are subjective.
There isn’t a one-size-fits-all solution to repaying debt. In fact, you can tackle your outstanding debt in multiple ways. That said, the two most common approaches are the snowball method and the avalanche method.
The avalanche method focuses on loans with the highest interest. Once you pay off your most expensive loan, you’d target the loan with the next highest interest rate. This creates a “debt avalanche.” The avalanche method is often the most cost-effective option, as it lowers your total interest expense.
The snowball method prioritizes loans with the lowest balances. While it’s usually not the most cost-effective approach, the snowball method is based on personal motivation. The idea is to use the momentum of repaying your smallest debt to your advantage. You pay off your smallest balances first and work your way toward your largest balance. This creates a “debt snowball.”
However, you can also take a step back and compare your good debt and bad debt. Good debt is usually a form of an installment loan, so your repayment plan is designated for you. Bad debt can often be expensive credit cards, which only require minimum payments. So, if you have poor spending and repayment habits, focusing on your credit card balances first could be the smartest route.
The most effective route is cutting expenses, freeing up extra money, and prioritizing loan payments over other wants. However, there are other repayment options that’ll help you become debt-free. Here are three debt repayment tips that can accelerate the process.
Consolidating your loans can help you convert multiple loans with high interest rates into a single loan with a lower interest rate. In turn, you can save time and money.
For example, if you have one or more credit cards with high balances and interest rates, you could consolidate those balances into a single personal loan. With a lower interest rate, your monthly payments won’t be as high, so you can pay the loan off faster.
Keep in mind, debt consolidation loans aren’t for everyone — you should assess your financial situation first.
Refinancing can save you a lot of money each month, especially when interest rates are low. A 2020 RateGenius report found that borrowers who refinanced their auto loans saved an average of $989.72 per year.
And you can even make it a win-win situation when you apply your loan savings to your outstanding debt. This approach saves even more money and helps you pay down your loan faster.
So, if your credit profile has improved or interest rates have dropped since you initially took out your loan, you might be eligible for an auto refinance loan with a better rate. If your credit score is bad — or rates are higher than when you took out your car loan — refinancing might not be as viable of an option.
If your debt burden is unbearable, and you’re really struggling to make ends meet, you might be able to work something out with your lender. Communication and transparency can go a long way. Although your loan agreement appears firm and unyielding, that doesn’t mean your lender isn’t willing to negotiate.
There are several routes you can take with your lender, such as a settlement. However, it’s important to note that debt settlements are more of a last resort option. Even if you have a good credit score, settlements can cause your score to drop severely.
The debt payoff process can be tricky. If you still can’t decide which loan to pay off first, any plan is better than no plan. At the very least, you should categorize your debt according to the characteristics mentioned above.
If you have a mix of good and bad debt, consider targeting bad debt first. This means high interest debt with loose repayment structures or unfavorable terms. That way, you can maximize interest savings and can continue receiving the ancillary benefits of good debt.
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