When it comes to debt reduction, we all want to be rid of our debt like yesterday. We can’t pay it down fast enough. “What debt should I target to pay off first?” I’m happy to hear this question because it signals that real thought and commitment is going into debt reduction. The conventional solution is to target the bad debt with the highest interest rate first. Most accountants will tell you this is the only answer. Home loans, student loans and even car loans can be considered good debts because they allow you to build equity and net worth or learn a high paying skill or just get to a potential job. Also they tend to have lower interest rates. Generally bad loans are unsecured debts like credit cards, finance company loans, or the very worst, payday loans. These loans only have a signature promising to pay them back. They carry a higher risk and higher interest rates to go along with it. So, if you ask a “numbers” person or an accountant, they will almost always tell you to target any surplus income towards the highest interest bad debt first. This isn’t bad advice but I would tell you there are other more unconventional factors to consider before deciding which debt to target first.
There are a couple of questions you need to ask yourself before taking the conventional route. Do I have any low or lower balance accounts that I could pay off sooner to free up that money? If I target a low balance debt (good or bad debt) will I have it paid off within 3 or 6 or 12 months? If I pay off this debt, will the money freed allow me to establish or boost my savings account? Am I a human or a robot? Okay, let me explain. First, if your balances are comparable or you just don’t have any significantly smaller accounts and you have at least some savings, you should stick to convention and pay off the high interest bad debts first. If you do have a low balance account even if it is good debt, you may want to target it so that you can free up money on a tight budget to establish or boost your saving. Savings is a key factor in paying down debt. Over three or four years of debt reduction, unexpected expenses and emergencies will come up. You need at least $1000 in savings so that you can deal with emergencies without borrowing more money or skipping a bill payment. If paying off a low balance will allow you to establish a savings or aid you in reaching the $1000 goal for savings, you need to consider it even if it isn’t one of your high interest accounts. Finally, in answer to the last question, you are a human! Let’s face it. Paying down debts isn’t easy. It takes courage and discipline. Debt reduction is often done on a very tight budget by necessity. As humans we need a little encouragement. If we are able to eliminate a debt in a fairly short period of time, it feels great! We can cross that debt off the list and pick a new target. One less bill to pay and forward momentum starts to build toward the ultimate goal of becoming debt free.
In the end if you have roughly equal balances and you have $1000 in your savings, you should go with convention and any surplus income should target high interest bad debt. If you have some lower balance accounts that could be targeted to be paid off within the first year of debt reduction, you should consider targeting them first even if they are considered good debt. Will they make your budget simpler? Can you establish or increase your savings to increase your security? Debt reduction isn’t all numbers. Remember to consider the human element and what will help you the most in reaching your goal of becoming debt free.