Cut down the credit card or ditch the student loan? Knock off the home equity line or get a jump on the car loan? Paying off money you owe is always a noble cause – but ditching some debts will benefit you far more than erasing others. Use the steps below to decide where to put your extra cash.
Step one: Know what kind of debt you’re dealing with. Money you borrow for a home or an education is considered “good debt.” That’s because these items can help boost your financial position. In addition, some home and student loan debt may be tax-deductible. There’s no need to put pressure on yourself to repay those loans as long as you can continue making regular installment payments.
Bad debt, on the other hand, includes anything that doesn’t improve your financial position and that you can’t pay for in full within a month or two, from a fancy meal at a lavish restaurant to a birthday gift for your spouse. Bad debt is usually in the form of credit card debt or a personal bank loan. You should tackle bad debt first.
Step two: Figure out what will give you the biggest boost. From a financial perspective, it’s smart to pay off your highest-rate bad debt first. After all, putting $500 towards a $3,000 credit card bill with an 18% interest rate will save you far more than paying off a $500 bill at 6%. That said, it can be worth prioritizing that smaller bill if you’ll gain a lot of psychological satisfaction from wiping a debt out in its entirety. “A small victory can give you the momentum to stick with the program,” says Anisha Sekar, VP of credit and debit products at Nerdwallet.
Step three: Consider the credit score effect. If you’re planning to buy a home or a car in the near future, it may be worth paying down any credit cards that are near their credit limit. That’s because lowering your so-called “utilization ratio” will have a positive impact on your credit score and potentially qualify you for lower interest rates.
Word of warning: If you're saddled with a lot of high-interest credit-card debt, you might be tempted to pay it off quickly by borrowing from your 401(k) or taking out a home equity loan. That’s usually a bad move. If you default on your home equity loan payments, you may lose your home. Borrowing from your 401(k) will cause you to miss out on valuable tax benefits. And if you quit or lose your job, you'll probably have to repay the entire borrowed amount within three months or face a stiff penalty.