Which debt should you tackle first?

It started with a student loan for college. Then you bought a car and a house. Then came some unexpected expenses that you charged your credit card with. Now you have a mountain of debt and you're not sure which one to tackle first.

It would be nice if there was a simple formula to answer this question, but it's not quite that simple. It all depends on your financial goals, your mindset, and the type of debt you have. Here's a quick look at three popular strategies for paying off debt and some advice on how to choose the right one in your case.

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Highest interest rate first

The most efficient way to pay off your debt is to compare interest rates. The thinking behind this is that if you eliminate especially high-interest debt first, you'll pay the lowest total amount. Here's an example to put that in perspective.

Imagine you have the following debts:

  • Mortgage: 200.000 US dollars with an interest rate of 4.25%.
  • Credit card 1: 5.000 US dollars with an interest rate of 24.
  • Credit card 2: 3.000 US dollars with an interest rate of 18.
  • Personal loan: 10.000 US dollars with an interest rate of 15%.

If you want to pay the lowest possible amount, you should pay the debt in order from the highest interest rate to the lowest – that is, credit card 1 first, then credit card 2, then the personal loan, and then the mortgage. That means you should only pay the minimum amount necessary on each type of debt, except for the one with the highest interest rate – which, of course, you should put as much money into as possible until that loan is paid off. Then you'd tackle the debt at the next higher interest rate.

The downside to this strategy is that if the debt with the highest interest rate is also a larger amount, it can take a long time for you to pay it off. This can discourage some people and make them give up on the strategy. If you think this might be a problem for you, then the next strategy might be a better fit.

Lowest balance first

Another approach is to start with the debt that adds up to the least amount first, and go from there. In the previous example, that would mean paying off credit card 2 first, then credit card 1, the personal loan, and the mortgage – in that order.

The advantage of this approach is that you can pay off your smaller debts quickly and feel encouraged by your achievements. It's also the fastest way to get debt collectors off your heels. The downside is that by ignoring the interest rate and focusing solely on the amounts, you will likely end up paying more because your expensive debt will continue to accrue more interest while you focus on the smallest balances.

Highest credit utilization first

If you plan to take out a new loan in the future, it's important to keep your credit score as high as possible. One of the main factors that determine your credit score is your credit utilization ratio. This is a measure of how much of your credit line you're using compared to the total amount you have available to you. For example, if you have a credit limit of 10.000 US dollars, and you usually have about 5.000 US dollars of it, your credit utilization ratio for that card is 50%. Ideally, lenders would like to see a credit utilization rate of less than 30%, the lower the better.

If the debt on your credit cards exceeds 30% of your credit utilization, you could pay off that debt before the others, even if other debts are higher or have higher interest rates. This will help raise your credit score, which in turn can help you get lower interest rates on future loans.

Customize the strategies for you

The three strategies above can all be great ways to prioritize your debt, but don't be afraid to adapt them to your situation. For example, if you have one or two small loan amounts of a few hundred U.S. Dollars, you can pay them off quickly and then prioritize your larger debts by interest rate.

There's no wrong way to pay down your debt, but different strategies have different pros and cons, and it's up to you to figure out which one is best for your situation.

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