Knowing how to rank your debt can open up new opportunities and improve your credit score. Unfortunately, too many Americans never achieve financial freedom because of a mountain of debt. The average household owes more than $203,000 on mortgages, student loans, and credit card debt.
But unless you’ve got over $200k lying around, one question may be more important than whether or not to pay down your debt. Which debt should you pay off first? Answering that question means you need to rank your debt and understand the different ways to pay it off.
Why You Should Know How to Rank Your Debt
So, you’re broke. You have some bills, but more importantly, you have a lot of debt. Chances are that you’re late on your credit card payments and mortgage and maybe even struggling with student loans. If this sounds like you, then there’s one important lesson you should learn: how to rank your debt.
Ranking your debt doesn’t mean putting higher interest rates at the top and lower ones at the bottom. Instead, it refers to paying off the most expensive debts first while making minimum payments on your other debts (if only for good karma) until they can either be paid off or payment arrangements can be made.
While it may seem like leveling out all of your payments is the best way to go, it’s actually counterproductive. You’re losing money every day you have outstanding debt, even if it’s only a few dollars. The goal, then, should be to pay off your debts as quickly as possible so that you can start saving money.
This isn’t easy, of course, but it’s doable. And by following some simple steps – like ranking your debts and making a budget – you can get on the right track and start reducing your overall debt load. So what are you waiting for? Start ranking those debts!
To easily remember and follow:
- Ranking your debts means paying off the most expensive ones first.
- This is the best way to save money and reduce your overall debt load.
- To get started, make a budget and rank your debts according to the interest rate.
- Then, focus on paying off the most expensive ones first.
- Continue making minimum payments on your other debts until they can be paid off or payment arrangements can be made.
Debt Avalanche or Debt Snowball?
The most popular ways to rank your debt are known as the debt avalanche and debt snowball methods.
The debt avalanche involves ranking your debt by interest rate with the highest-rate debt on top to be paid off first. Then, you make all your minimum payments but make extra payments on the loans with the highest rate until they are paid off. It’s an obvious idea that helps save money by paying off high-interest debt more quickly. As a result, you’ll pay less interest over the long run.
The debt snowball method isn’t as well-known but might be the better choice. Instead of ranking your debt by interest rate, list your accounts from smallest to largest and make extra payments on the smaller debts first.
You’ll pay more money in interest compared to the avalanche method, but individual debts will drop off much quicker. The idea is that seeing the debts drop off is great motivation to keep saving and paying off your debt. Too many people struggle with their debt plans and need all the motivation they can get to keep on track.
Rank your Debt on Credit Score Factors
Focusing solely on the debt avalanche or snowball methods can miss an opportunity to improve your credit score. Your credit history and amount owed are the largest credit score factors, making up more than half of your credit score. In addition, the time you’ve been building credit and any new credit also affect your score.
Ranking your debt won’t change these four factors. You can’t change your credit history; the amount owed is affected by how much you pay, not by which debts you pay off first or last. You can improve your credit score by ranking your debt on the final credit factor, types of credit that accounts for 10% of your score.
The credit bureaus favor non-revolving credit over revolving credit in your credit score. This is because non-revolving debt has a fixed payoff date and payments, like your mortgage and car loan. On the other hand, revolving debt does not have a payoff date, and you can continuously borrow more; consider debts like credit cards and a home equity line of credit.
Revolving debt reduces your credit score compared to other debt because you can keep borrowing and quickly get yourself in trouble. Ranking your debt by credit score factors means putting the non-revolving debt on top of the list to pay off first. Then, as your non-revolving debts drop off, your credit score increases, and you get access to cheaper credit.
This trick to increase your credit score by paying off revolving debt with a non-revolving loan is one of the reasons debt consolidation is the most popular use of personal and peer loans. The idea is to take out a three- or five-year personal loan through a site like PersonalLoans to pay off higher-rate credit.
The monthly payments help improve your payment history, the interest rate savings mean lower payments, and the better type of debt helps increase your credit score. Peer lenders like Lending Club may offer better rates though you’ll need a credit score of 640 or higher, while PersonalLoans.com accepts borrowers with credit as low as 580 FICO.
Good Debt, Bad Debt
There is yet another way to rank your debt, one that most people don’t think about, but it will give you a whole new perspective on credit. Blindly looking at all debt as bad means missing out on great financial opportunities.
Debt is a financial tool. It can help you build something which wouldn’t otherwise be possible, paying for an education or getting your business off the ground. However, it’s the use of bad debt, credit cards, and payday loans that you should avoid.
Example of good debt and bad debt ranking:
- Payday loans (Worst!)
- Credit cards
- Car loans
- Business loans
- Mortgage Debt
- Student loans
Some of the ‘bad’ debt at the top of the list isn’t necessarily bad but depends on your interest rate if you regularly use credit cards to rack up rewards points and get thousands in free travel every year. Only charge as much as you have in the bank and can pay off at the end of the month to avoid any interest charges, so it’s just a 0% loan for a few weeks.
Putting the three ways to rank your debt together means thinking about how they all fit together. You might start by deciding on the debt avalanche or snowball method. Then, with your debts listed according to one of these two methods, think about each account and how it affects your credit score.
For example, you might decide to move one of the non-revolving credit accounts higher on the list to pay it off more quickly. You might also want to move some of your bad debt accounts higher on the list, resolving to pay them off and never fall down that rabbit hole again.
However you plan to rank your debt, continue making the minimum payments, and pay a little extra each month to get out of debt. Whatever you do, stay motivated and know that financial freedom is just a few payments away. Getting out of a mountain of debt can open up a whole new world of choices, from job mobility to better rates on new credit.
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