By Casey Bond / Updated: Sep 20, 2019

Guide on Setting Loans Repayment Priorities: Which Loan to Pay Off First

How to Choose Which Loan to Pay off First

Tired of paying multiple debts? Worry no more. It might be quite challenging to determine which debts you will pay first but setting out a good plan can help you to overcome the struggle.

Also, regardless of the reason that got you in debts, you are not alone, a research done by the Pew Charitable Trusts shows that nearly 80% of Americans are living with some debts.

Even if your debts resulted from accidental overspending or in an expected emergency, don’t be ashamed of what you owe, and start taking steps towards achieving your well-deserved financial stability.

This expert guide will help you find the best strategy that you can apply to repay your loan. As both analyzed approaches have pros and cons, it is up to you to research your options and decide which strategy would best fit your circumstances.

As a first step, we have outlined the common types of debts to help you know under which category your loan is classified. Check them out.

Main Types of Debts

  • Secured Debt
    Secured Debt is any form of debt which is backed up by a collateral asset. Before giving out a secure debt, the lender must carry out a thorough background check of the borrower to confirm how responsibly the debt will be paid. For instance, if you need a car loan, the lender gives you the cash, but in case of a default, the bank is legally allowed to reclaim the car ownership.The same case applies when buying a piece of land, or building. All secured loans have a reasonable interest rate, which is usually based on the value of the collateral, your level of income and your net worth. Examples of secured debts include vehicle loans, savings- secured loans, title loans, and pawnbroker loans.
  • Unsecured Debt
    Unlike the secured loan, this type of loan does not need collateral. The lender gives out the cash in utmost good faith following your promise that you will pay. However, a contractual agreement still bounds you meaning that legal action can be taken for you in case you default.Since there is not an asset used, the loan is quite risky for the lender, and thus it is characterized by a higher interest rate. Examples of the unsecured debts include signature loans, medical bills, gym membership loans, credit cards, small business loans, peer to peer loans, cash advance, student loans, and short-term loans.
  • Mortgages
    Mortgages are loans used to purchase homes and buildings, where the real estate is used as the collateral. Typically, mortgages have low-interest rates which are subject to tax deductions. The loan repayments period terms are long-term thus most of them are payable up to 30 years.
  • Revolving Debt
    Revolving debt is a deal made between the borrower and the lender to allow the consumer to keep borrowing on a recurring basis. An excellent example of this kind of debt is a credit card. The card has a limit, which allows the user to spend freely until he/she reaches the threshold. The payment terms depend on the specific type of credit card as well as the amount of loan. The debt can either be secured or unsecured.

The Two Main Strategies You Can Use To Pay Multiple Loans

If you have more than one loan, there are different approaches you can take to settle the amounts. Discussed below are the two primary ways:

Debt Avalanche Method

This method consists of paying the debts with the highest interest rates first. It means that although you are still contributing to the repayment of the other loans, you are focusing more on the investments with the relatively higher interests. Many experts recommend this method since it is believed to save the borrower much cash. How? Since the interest is high, getting rid of those costly debts will save money in the long run.

Debt Snowball Method

By using this method, the borrower settles the debts by first focusing on the smallest debt balances irrespective of their interest rates. Typically, this method is more expensive than the first one although psychologists and researchers have found that the technique motivates you since the progress is visible. As you start by paying the smaller balances, you will gradually get rid of them and probably remain with only one debt.
How do Debt Avalanche and Debt Snowball Work

How to Pay Off Debt Using Debt Avalanche and Debt Snowball Methods?

To help you decide on the most appropriate method for your situation, check out this example:

List All Your Loans

Suppose you always allocate $800 every month for debts repayment, and you have the following debts.

  • $10,000 student loan with an interest rate of 5% and the minimum payment is $150.
  • $5,000 personal loan with a rate of 3%, and a minimum payment of $70
  • $9,000 credit card loan with a rate of 20%, and a minimum payment amount of $250.

So, you have a total debt of $24,000 and a total minimum payment of $470.

And now let’s see how you can pay the debts using both methods.

Paying off Debts Using the Debt Avalanche Method

As mentioned earlier, the debts with the highest rates are paid off first using this method. You will first pay the minimum payable amount of credit card debt. You will remain at $280, which you will use to pay the remaining loans. By using this method, you will have paid a total of $26,919 within 36 months.

The snowball method is best if:

  • You get easily motivated through quick wins
  • You don’t mind paying a substantial amount at the end provided that you will have motivation all through

Paying off Debts By Using the Debt Snowball Method

Pay off the smallest debt first. You will start by paying the extra $280 to the personal loan, followed by the credit card loan then finish with the student loan. By using this method, you will pay $28,182 within 38 months.

As you can see, the avalanche method will save you $1263 and also clear off your debts 2 months earlier.

The avalanche is the best for you if:

  • Your main aim is to save money
  • You can maintain a debt repayment discipline even without motivation

Does This Mean That Avalanche Debt Repayment Method Is Better?

The snowball amount is higher by $1263, which seems like a huge difference. However, the interest difference is just $25 per month. Researchers argue that most people tend to be worried about the final amount that they would have paid for the loan, and not what they are left within their pockets.

It implies that if you have two loans amounting to $500 and $1000, you would be happier and motivated if you paid $400 to the $500 debt other than splitting the amount and contributing $200 to each loan.

Although the payment is still the same, the first one makes you feel like you have accomplished something bigger since the credit is 90% paid.

You see, both methods have their pros and cons and thus making the decision entirely depends on your personal preference.

Works Cited

1 Forbes “Debt Snowball Versus Debt Avalanche: What The Academic Research Shows”

2 Consumerism Commentary “Debt Reduction Methods and Philosophies: Snowball, Avalanche and More”

3 Dave Ramsey “How the Debt Snowball Method Works ”

4 Consumerism Commentary “The Debt Snowball”

5 Everydollar “The Debt Snowball: How and Why this Method Works”

6 Nerdwallet “How to Use Debt Avalanche”

7 Consumerism Commentary “The Correct Way to Pay Off Personal Debt: The Debt Avalanche”

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