How To Determine Which Loans To Pay Off First
Posted on January 15, 2021 in Loans
It’s safe to say that just about every American has some form of debt. Between student loans, credit cards, auto loans or mortgages, paying them off can be quite a struggle, especially when considering which types of debt to focus on.
There are a few different methods and ideas for selecting what loan to pay off, but no one method is the right answer every time. It matters on the details of the loan and the borrower’s specific open accounts.
Types of Loans
Before being able to effectively pay off a loan it’s important to understand the nature of loans in general.
There are essentially two different types of debt: installment loans and revolving credit. Both have their own sets of pros and cons depending on the nature of the loan required.
Installment loans are broken down into equal monthly payments, or installments, and are set to be repaid over a specific amount of time. An example of this would be an auto loan for $20,000 with a 3% interest rate paid back over a 60 month period. The interest would be calculated and added to the total amount and then broken down into 60 equal payments. For a borrower with unhealthy spending limits, an installment loan can help from putting them further in debt. Since it’s a one-time transaction the money borrowed is capped and can not be run up higher because it’s not revolving, it’s a flat loan.
Revolving credit is a little bit different. This is an open line of credit that can be used for any amount up to its limit and is paid back accordingly. This would be how credit cards work. The card is used and the debt is created and eventually paid back but without a set repayment period, and the monthly payment would be based on a percentage of the balance. This style of loan can be tricky for those with unhealthy spending habits as the more the credit line is used, the more will be owed. It’s easier to use a credit card than to take out an installment loan, but it comes with a higher responsibility because if an individual is not staying on top of their finances, credit card debt can balloon quickly.
Things To Consider When Selecting A Loan To Repay
Now that we’ve covered the different types of loans it’s much easier to consider which one to pay back and in what order. With both installment loans and revolving credit, the minimum payments should always be made without exception. The interest rates, late fees, and other penalties of missing payments can cause a whole host of new issues financially so it’s important to make the minimum payments regardless of loan type.
When it comes to which loan to put extra money towards to pay off faster there are several other factors to take into consideration such as:
> Interest Rate
In most cases the interest on a loan can be what truly causes a little bit of debt to skyrocket into an overwhelming amount of debt.
In general, installment loans will have a lower interest rate because they will be repaid over such a long period of time. These interest rates will typically stay around the single digits but can change depending on credit score and loan details. Revolving credit is the opposite in that regard. Interest rates are much higher for credit cards because they are without the concrete details of amount owed and repayment time.
For the most part interest rates on revolving credit are typically in the double digit range but can of course vary depending on promotional offers or credit scores. Some personal loans, such as payday loans, title loans or bad credit loans, can ever reach triple digits in their respective interest rates.
When it comes to interest rates, the higher they are and the longer it takes to repay, the more money it will ultimately cost the borrower.
> Loan Terms
Depending on the details of an installment loan, repayment time should absolutely be a factor under consideration while selecting the loan to focus extra resources.
For example, an auto loan with several thousand dollars remaining, a single digit interest and several years left to repay shouldn’t be the primary focus when compared to a payday loan of a few hundred dollars, a triple digit interest rate and several days left to repay.
Revolving credit can be a little harder to consider because the nature of the loan is very fluid.
A good habit to get into when dealing with revolving credit is to keep the total debt at 10% or lower of the maximum credit available. Looking at the specific terms and details of a loan can make the decision on which to pay first much easier.
> Spending Habits
When it comes to revolving credit, someone with well-disciplined spending habits will most likely avoid most of the pitfalls and dangers possible. However, undisciplined spending with a large credit limit can result in a lot of trouble very quickly.
Interest rates of revolving credit lines are very often in the double digit range, so the longer it takes to repay, the more will be owed. Also, as stated before, a good habit to get into when it comes to revolving credit is to never go above 30% of the maximum credit available if possible, and to pay down to get to 10% as quick as reasonably possible.
This is what is known as a credit utilization rate, and the lower, the better. When it comes to an individual’s credit score, the higher the credit utilization rate, the more harm it can cause, so keeping spending down and repaying whatever debt owed should also be on the list of important factors being considered.
Debt Avalanche vs. Debt Snowball Methods
There are two different but distinct methods to consider when repaying debt. Although having similar names, there are some very key differences between the two methods of repaying debt known as debt avalanche and debt snowball.
In the financial community, the debate continues as to which is the superior method, but ultimately it often depends on an individual’s specific situation.
- Debt Avalanche: This method is arguably the more popular of the two but not necessarily the better option. With the debt avalanche, first you start off by allocating enough funding towards each loan to cover the minimum monthly payments. Then, whatever money or resources is left over and available will go towards the loan with the highest interest rate. The idea here being that the higher the interest, the more money it will ultimately cost the borrower. Factors such as total amount owed and available repayment period are largely ignored and the only thing considered is the interest rate.
- Debt Snowball: As with the previous method, the first step is to have enough money set to make the minimum monthly payments on all debts. However, the key difference is the remaining money and resources is focused on the loan with the smallest amount owed instead. Interest rate and repayment period are ignored and instead the total amount remaining is the most important factor. The idea here being that while in the long run, interest rates will cost the borrower more money, the closing of accounts will help keep the financial plan on track and also free up the money that was allocated towards accounts that are now closed, providing more funding to the newest lowest total.
The Takeaway: While there are several different methods and factors to weigh, at the end of the day, not one factor is more important than the other and the borrower should choose based on the specific of the loan, taking all factors into consideration.
When repaying loans and debts, the number one important focus is to at least make the minimum payments. Failure to do so can end up costing more than just money, so at the very least, the minimum must be covered each month. However, once that is covered there are several critical factors to consider but ultimately there is no wrong way to go.
As long as the debt is being repaid, however slowly, progress is being made and chipping away at debt is the only way to stay on top of it.
For a little extra help getting on top of your debt, get in touch with us today and get a finance expert on your side.
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