Wednesday, March 29, 2023
HomeValue InvestingShould You Pay Off Personal Loans or Credit Cards First?

Should You Pay Off Personal Loans or Credit Cards First?


When you’re in debt, it’s important to have a plan for how you’ll pay back your loans. If you have both personal loans and credit card debt, you might wonder which you should pay back first.

It’s important to make the minimum payments on all your loans, but with minimum payments, it may take years to pay off the balance of your credit card or loan. If you have the cash to do so, you’ll want to make additional payments to pay the loan off faster.

But which should you pay off first?

How to Determine Which Debt to Pay First

If you have multiple debts, you should come up with a plan to determine which loans to pay off first. There are two primary strategies that people use to prioritize debts: the snowball and avalanche methods.

1. The Debt Snowball Method

The debt snowball method focuses on paying off loans with the smallest balances first. You make minimum payments toward all your loans and put any additional money that you can toward the loan with the lowest balance.

Once you pay off one loan, you can put your money into the next smallest loan. Continue this process until you’ve paid off all your debts.

There are a few advantages to using this strategy.

One is that it gives you a quicker sense of accomplishment. Paying off loans feels good, so focusing on the ones that you can pay off most quickly is an easy way to get a win.

Another is that it frees up space in your monthly budget. If you’re struggling to make, ends meet, paying off even a small loan gets rid of one of your monthly bills, and the corresponding required payment. That can be a huge relief if you have a tight budget.

The biggest drawback of this strategy is that it may result in paying more interest overall because you focus on the balance of the loan rather than its interest rate.

This strategy gets its name from the idea of a snowball that grows and accelerates over time. As you pay off smaller debts, you can put more and more money into paying your larger ones.

2. The Debt Avalanche Method

The debt avalanche prioritizes loans with the highest interest rates first. This will save you the most money overall but may not deliver the same emotional satisfaction as the snowball method.

As with the snowball method, you make minimum payments toward all debts except the one with the highest rate, which you put all your extra cash toward paying. Once you pay off that loan, put your extra funds towards the loan with the next highest rate, and so on.

The primary advantage of this method is that it will save you more money than the snowball method.

Reducing the balance of high-interest debt reduces the amount of interest that accrues overall. You’ll pay the least interest using this method.

The drawbacks are that you may not get the immediate satisfaction of paying off a loan like you would with the snowball method. It also won’t eliminate a required monthly payment all that quickly, which can be a problem for people with tight budgets.

Which Debts are Best to Pay Off First?

The answer to which debt is best to pay off first depends on the strategy that you intend to use.

In general, credit cards have very high interest rates, much higher than the typical personal loan rate. If you plan to use the avalanche method, you’ll almost always want to pay off your credit cards first. If you plan to use the snowball method, it will all depend on the balance of your debts.

However, before you choose one of the two strategies, there are a few other things to consider.

1. Paying Your Credit Card First

If you’re using the avalanche method, credit card debt will naturally be first in line, thanks to the high interest rates that credit card charge.

However, there are a few other compelling reasons to pay off credit cards before personal loans.

One is that credit cards tend to have variable interest rates, while many personal loans have fixed rates. That means that the interest rate on a credit card could rise without much warning, making the debt even more expensive. Depending on how much the rate increases, the required monthly payment may go up, which could stretch your budget.

Making just the minimum payment puts you at risk of rising rates.

Another reason to prioritize credit card debt is that it can have a big impact on your credit score. One of the most important factors in calculating your credit is your credit utilization ratio. To find your utilization, divide your credit card debt by your total credit limits across all cards.

The lower your utilization ratio, the better your credit score will be. That makes paying off credit card debt a good way to improve your credit score.

2. Paying Your Personal Loan First

Paying off your personal loans may be appealing if they have relatively low balances. Paying off the loan will free up space in your monthly budget and can feel like an easy win.

However, many personal loans have fixed interest rates. That means they offer a degree of certainty that credit cards with variable rates don’t have. They also tend to have lower rates than credit cards, which means you can save more money by prioritizing your credit card debt.

Before you choose to pay off a personal loan first, be sure that it does not have a prepayment penalty. If it does, you’re better off just making your regular payment until the loan is paid.

Paying down your personal loan balance may also hurt your credit score. Active accounts have more impact on your credit score than closed accounts. Paying off an older loan can also reduce the average age of your active accounts. If you don’t have another installment loan, paying off a personal loan could also affect your credit mix.

If you’re concerned with building your credit, the best course of action will usually be to simply pay the personal loan off on schedule, making every payment on time.

There is an exception to that rule. If you are considering a mortgage, you may need to reduce your debt-to-income ratio. If that’s a priority, paying off your personal loan early will help.

Unless you have a very tight budget and need to get rid of a monthly loan payment, it’s usually best to use the avalanche method and focus on high interest debt before cheaper, fixed-rate loans.

Other Ways to Manage Debt

Whether you’re simply looking to save money or need help getting out of a pile of debt, there are other strategies that you can turn to.

1. Debt Consolidation

Debt consolidation involves getting a new credit line and using the proceeds to pay off your other debts. This turns multiple loans into a single one with one monthly payment. In some cases, you can convert variable-rate loans to fixed-rate, lower the interest rate, and reduce your monthly payment.

Personal loans and balance transfer cards with a 0% APR promotional period are both popular ways to consolidate debt, but both of them require good credit to get a good deal.

2. Credit Counseling

Credit counseling involves working with a professional to get advice on how to manage your money and debts, build a budget, and eventually pay off your loans.

Credit counselors offer debt management plans. You make one monthly payment to the counseling agency. They will pay your creditors and negotiate better terms. This is an effective way to consolidate debt if your credit is already seriously damaged.

It’s important to do your due diligence when looking into these services. The industry is rife with less-than-savory companies looking to profit from people’s desperation.

3. Debt Settlement

Debt settlement involves negotiating with your creditors to accept a reduced amount as full payment for your debt.

There are two main obstacles. First, you’ll need to offer a lump sum payment to persuade your creditors to accept a settlement. It’s not easy to put together a lump sum when you’re struggling with debt.

Debt settlement can also seriously damage your credit, making this an option to use only if you are truly unable to pay your debts.

4. Bankruptcy

Bankruptcy is a last resort option for people who have no way to pay their debts. It is a legal process administered by federal bankruptcy courts.

If you’re considering bankruptcy, you will need to understand how bankruptcy works and the difference between Chapter 7 and Chapter 13 bankruptcies.

Conclusion

In general, if you’re looking to save the most money, the best thing to do is pay off your credit cards first. They’ll have higher interest rates than personal loans, letting you reduce the total amount of interest that accrues.

Focusing on smaller debts to get the quick satisfaction of paying off a loan may be appealing, but is only a good idea when you have a very tight budget, and eliminating a monthly payment can provide relief.

RELATED ARTICLES

LEAVE A REPLY

Please enter your comment!
Please enter your name here

- Advertisment -
Google search engine

Most Popular

Recent Comments