Debt comes in a number of different forms. Regardless of the type of debt, debt has to be paid back. Carrying heavy amounts of debt from one fiscal year to the next undermines net worth, credit score, and even peace of mind. Paying down debt, for many, has to be done in a deliberate and well-planned manner. A borrower may look at his or her credit card debt and also at installment loan debt and wonder what debt should be paid down first. Simply asking such questions is a good first step towards improve fiscal health.
Differences Between the Debt
Credit card debt and installment loan debt are quite different in structure. Credit card debt is a form of revolving debt. Lines of credit fall under this delineation as well. Basically, a credit limit is afforded to a borrower. The borrower then pay down the balance while also borrowing on the remaining credit limit.
Installment loans are fixed loans. If $10,000 is issued on the loan, the $10,000 is a one-time issuance. Unlike credit cards, paying $1,500 to reduce the balance to $8,500 does not mean there is now $1,500 in credit left accessed. A great many of these types of loans are secured — collateral-based — loans such as home mortgages and auto loans. Unsecured installment loans exist as well. A student loan would be such an example. A basic personal loan would be another.
Paying Off The Debt
Paying way more than the minimum monthly amount on every single loan account is just not possible for everyone. A certain debt account has to be prioritized over others. For those perplexed over what debt to pay down first, conventional wisdom dictates credit card debt is the best to pay down first. The reasons why so many suggest paying off credit card debt first are varied. All the reasons do make sense though.
Credit card interest rates are surely going to be much higher than a home mortgage, auto loan, or home equity line of credit. Paying 19% or more on credit card debt makes getting a balance down to zero extremely difficult when paying the minimum amount. Getting out from under a significant amount of interest debt simply saves money. The money saved off of the interest payments could then be put towards paying down the balance of the installment loans.
Paying off credit card debt also helps boost credit scores. Secured debt is logged on a credit score, but unsecured credit card debt has a greater impact. High levels of credit card debt drags a credit score down. Improving a credit score has a ripple effect of other benefits. Once a score improves, the ability to refinance a mortgage or other installment loan becomes more realistic. Getting better interest rates on the refinancing is more possible as well.
The theme of lowered interest rates leads to quicker payoffs applies to secured debt as well. No one wants to drag out an auto loan or personal loan’s “zero balance date” longer than is necessary. Dropping an entire point in interest absolutely will help with the cause of paying the debt down.
Once a home mortgage is paid off, the bank no longer holds the title. The title is turned over to the owner who has been paying off the mortgage for years and years. To some, paying off a mortgage is the number one priority. They may even have plans on paying off the mortgage and transferring credit card debt to a home equity loan. A home equity loan is going to come with a far lower rate of interest than a credit card.
Each and every person’s situation is different. If a small amount of money — say $5,000 — is left on the mortgage, maybe paying off the mortgage first makes more sense. Then again, the interest on a mortgage is tax deductible. Losing a deduction and paying another year or 18 months worth of credit card interest may be a less-desirable option. Those with a mortgage do need to think about the pros and cons of paying off a mortgage first before wiping out credit card debt.
Just be sure to take action to get rid of debt as quickly as possible.