Which Debt Should I Pay First?
I think most of us would like to be free of debt.
Perhaps that's why we get inspired when we hear stories of plain old folks like us working hard to get debt free. After all, if they can do it, surely we can, right?
It's a worthy goal, but one that needs to be approached the right way.
So, before heading off willy-nilly paying off every last cent of the first debt that comes to mind (like maybe that student loan) or whichever is largest (aka your mortgage) light years ahead of schedule, it's important to first meet any other debt obligations that might take priority.
Choosing to pay the wrong debt first could turn out to be costly. You should, of course, always make at least the minimum payments on your debts, but before tying up your money by making extra payments on any single debt, be sure to sit down and list your obligations from most to least urgent, making sure you have enough to cover those obligations BEFORE paying anything down early.
Here are some thoughts on debt priorities:
Housing Costs - A mortgage probably should be first on the priority list. This includes second mortgages or home equity loans. This is because failure to pay your mortgage, or even falling behind a bit, can impact your credit rating in a negative way. Not only that, but you could be subjecting yourself to foreclosure. The implications of that can haunt you for years, making it difficult to get loans in the future or even to rent a home.
Other Secured Debt – Secured debt, such as an auto loan, is debt backed up by some kind of collateral. Secured debts take payment priority over most other types, especially unsecured ones. That's because if you fail to pay a secured debt, the lender can take the collateral. For a car loan, for example, the finance company can repossess the car, which in turn could affect your ability to get to work, generate income and pay your other debts.
Property Taxes – These obligations might be considered in the housing costs category referred to above, and in fact, many advisors might list them right behind your mortgages in order of priority. That's because if you don't pay them, the taxing authority can take the related property. Adding insult to injury, you still owe the mortgage. Failure to pay your property taxes is extremely costly; never let that happen.
Income Taxes – Following closely behind property taxes are your income taxes. That's because the IRS and state taxing authorities have the power to attach liens and take pretty much anything you have – homes, boats, cars, bank accounts, even your wages.
And here's some practical advice; never fail to file your income tax returns just because you currently don't have the money to pay the taxes. File them anyway!
The penalties are dramatically lower if you file than if you don't, even if you can't pay at the time. They will work with you to establish a payment plan when you file. However, not filing brings the full force of Uncle Sam down upon you.
Student Loans – Federal student loans especially should be a priority. That's because like income taxes, they have the brute force of the IRS behind them. If you default, the IRS will come calling, including taking tax refunds. And student loans generally are not eliminated even in bankruptcy.
Medical Bills – Did you know that medical bills are one of the top causes of bankruptcy in the United States? A hospital or other provider can sue or send your debt to a collection agency. And can you imagine if you couldn't see your doctor again or use a medical facility because of a medical bill default? Not a consequence you want to face, I guarantee you.
Unsecured Debt – As you might imagine, this is the opposite of secured debt, in that this debt does not have collateral attached to it. Unsecured debt, while it can be expensive and stressful to have, is down on the list because such debt does not immediately threaten your home or job.
Of course, that does not mean it isn't important to pay. Failure to pay unsecured debt also negatively affects your credit rating, which of course can follow you everywhere. Poor credit history and lower credit scores can cost you money, raising the cost of many goods and services, like insurance for example. It can also keep you from getting credit at all!
When tackling unsecured debts, do so from highest interest rate to lowest. By eliminating the most expensive debt first, you end up paying less over the long haul than if you to start at the other end.
Of course, sometimes there is a positive psychological effect of paying off a small debt just to be rid of it. It feels good to get that done, and can help you build momentum to tackle more difficult and larger ones.
Getting out from under debt is a healthy financial achievement. Just be sure you approach it with wisdom and clarity, making sure you protect all areas of vulnerability.
