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What debt is best to pay off first
How do you figure out what debt to pay off first. Home prices are at historic highs and many homeowners have the opportunity to do a cash-out refinance from the equity in their homes. However, there are instances where the proceeds from the cash-out refinance will not be enough to pay all outstanding debts of the borrower. So, if that is the case, what debt should you always pay off first. What are the three biggest strategies for paying down debt. Should I pay the debt with the highest monthly payment first?
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When figuring out which debt to pay off first, especially when doing a cash-out refinance and the proceeds aren’t enough to cover all your outstanding debts, it’s important to prioritize strategically. Here’s how you can approach this by prioritizing debt repayment:
Prioritizing Debt Repayment
High-Interest Debt:
Credit Cards and Unsecured Loans typically have the highest interest rates. Paying off high-interest debt first will save you the most money in the long run because you reduce the amount of interest accruing over time.
Why First: The faster you eliminate high-interest debt, the less you’ll pay overall, freeing up more money to tackle other debts.
Secured Debt:
Mortgage, Car Loans: Secured debts are tied to assets (your home, car). While it’s essential to keep up with these payments to avoid foreclosure or repossession, you don’t necessarily need to pay these off first if they have lower interest rates. However, you should ensure these payments are manageable.
Why Important: Failure to pay secured debt can result in losing the asset securing the loan, so maintaining these payments is critical.
Debts Affecting Credit Score:
Delinquent Accounts: If you have debts that are in collections or delinquent, paying these off can help improve your credit score. This could be especially important if you’re looking to refinance or secure other types of credit.
Why Considered: Improving your credit score can open up better refinancing options or lower interest rates on other debts.
Three Biggest Strategies for Paying Down Debt
Debt Avalanche Method:
Focus: Pay off debts with the highest interest rate first, regardless of the balance.
How It Works:
- Make minimum payments on all debts except the highest interest rate.
- Allocate any extra money toward that debt.
- Once it’s paid off, move to the next highest interest rate debt.
Benefit: Saves the most money on interest over time.
Debt Snowball Method:
Focus: Pay off the smallest balance first, regardless of the interest rate.
How It Works: Make minimum payments on all debts except the smallest one. Apply any extra funds to that debt until it’s paid off, then move to the next smallest balance.
Benefit: It provides psychological motivation by giving you quick wins, which can keep you motivated to continue.
Debt Consolidation:
Focus: Combine multiple debts into a single loan with a lower interest rate or more manageable payment terms.
How It Works: Use a debt consolidation loan, balance transfer, or cash-out refinance to pay off multiple debts, leaving you with just one payment to manage.
Benefit: Simplifies payments and may reduce overall interest costs.
Should You Pay the Debt with the Highest Monthly Payment First?
Paying off the debt with the highest monthly payment can be a strategy if you need to improve your cash flow quickly. Reducing your monthly obligations can free up money to pay down other debts faster or address immediate financial needs. However, this approach might not save you the most money on interest in the long run, especially if the high-payment debt has a lower interest rate than others.
Summary
Pay Off High-Interest Debt First: Generally, prioritize high-interest debts, as they cost you the most over time.
Consider Cash Flow Needs: If cash flow is tight, consider paying off the debt with the highest monthly payment to free up money.
Use a Strategic Method: Choose a debt payoff method (Avalanche, Snowball, or Consolidation) that aligns with your financial goals and psychological needs. The right approach depends on your financial situation, goals, and priorities. Consulting with a financial advisor also helps tailor the best strategy for your needs.