If you have a lot of debt, or simply more than you would like to have, it's definitely a good idea to make paying it off a priority. However, to make your efforts as effective as possible, you need to pay off your debt in the right way. There are some types of debt you need to get rid of as soon as possible, some that should be your second priority, and some that is actually OK to make the minimum payment and let the loan term play out.
Here's how to prioritize paying off your debt and why it's so important to your bottom line.
Highest interest means highest priority
Before you do anything else with your extra money, including setting it aside to invest, you need to get rid of your high-interest debt. For most people, this refers to credit cards, but there are some borrowers with auto and other loans that have double-digit interest rates.
Here's why – even if you are an excellent investor and can achieve say, 12% returns every year, you're still going to lose money over the long run if you're paying 20% interest on credit card debt. Once you get rid of this burden, real progress toward your financial goals can be made.
Pay off debt on cars and student loans next
Once your high-interest debt is eliminated, then it is OK to pay extra on your other outstanding debts. A lot of people want to pay down their car faster than they have to, or pay extra on their student loans, and this is a good goal to have.
And, just like with credit cards, it pays to prioritize these from highest interest rate to lowest. For example, if your student loans have a 6.8% interest rate and your car loan is at just 5% interest, your extra money should go toward your student loans first.
Some debts are actually good
If you have a low interest rate, a mortgage can actually be a good debt to hold. Basically, mortgage rates are so low today that you can actually earn better returns by taking your extra cash and investing it.
Let's say that you owe $200,000 on a 30-year mortgage at 4.25% interest, and that you have an extra $25,000 sitting around. If you pay $25,000 extra toward your mortgage, you'll save yourself up to $19,300 in interest charges, depending on how much time is left on your loan term.
However, if you choose to invest that money instead and average 7% annual returns, which is a pretty conservative estimate, historically speaking, you'll accumulate more than $165,000 in returns on your investment over a 30-year period.
So, you may be better off making just your normal monthly mortgage payments, and allocating your extra money elsewhere.
What if you do it wrong?
Let's say that you have $10,000 in credit card debt at 18% interest and a $20,000 60-month car loan at 6% interest, and that for some reason you are determined to pay off your car as soon as possible. The standard minimum payments on these would be about $200 and $387, respectively, depending on the particular terms of your credit card agreement.
We'll also say that you have an extra $5,000 to pay down your debts. At first glance, it may sound like the same overall effect, but it's not. If you pay $5,000 of your credit cards off, it will cut the amount of interest you pay by $75 per month initially, or by about $900 per year. However, if you pay down $5,000 of your car loan, your interest savings will be just $25 per month.
Of course, the exact savings will depend on your particular circumstances, but you'll always save money over the long run by paying your highest-interest debts first.
In other words, by putting you extra money toward the higher-interest debt, you will end up paying less interest through your normal monthly payments and more toward paying down the principal.
So, while paying any of your debt down is better than none at all, prioritizing your debts correctly can save you tons of money in interest charges and reduce the amount of time it takes you to become debt-free.