Which loan should I pay off first?
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UPDATED: Apr 17, 2013
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If you’re struggling under multiple kinds of debt, the best strategy is to assess your financial situation and develop a plan to pay off each loan. Individuals with serious debt problems should focus on four kinds of financial obligations: basic necessities, secured debt, unsecured debt, and savings.
Food, clothing, and shelter are three things you shouldn’t go without, even in the face of mounting interest payments. Kevin Gallegos of Freedom Financial Network, LLC, recommends taking care of your basic needs first, but not going overboard.
“This does not mean gourmet dining, a trendy wardrobe and a mini-mansion are necessities,” Gallegos said.
Additionally, make sure that your home and utility costs do not exceed 30 percent of your income. If your basic expenses take up a large part of your income, consider cutting back. Stop going out to dinner and cook meals at home instead. Bring your lunch to work, carpool, or consider getting a roommate.
Secured and unsecured debts
Once you’re ready to begin paying back your debt, focus on loans that are tied to physical assets, such as your home loan and auto loan.
“If you do not pay these bills on time, you could lose the asset, which – in the case of a car or home – can be devastating,” Gallegos said.
Unsecured debts include student loans and credit card loans. While student loans are considered investments, borrowers should pay them off diligently if possible. Student loans can’t be absolved through bankruptcy, and the government can garnish the wages of borrowers who default.
Saving for a rainy day is a good way to avoid situations that require taking out spur-of-the-moment personal loans.
“One of the best ways to avoid debt is to have a savings fund for emergencies,” Gallegos said. “Even just a few hundred dollars can make the difference between charging and not charging an unexpected expense.”
Gallegos recommends creating a small fund that covers six to nine months of personal expenses.
The best approach to debt
When choosing which personal loan to pay off first, there are two methods financial advisers promote: the snowball method and the avalanche method.
The avalanche method involves tackling the loan with the highest interest rate first, whereas the snowball method involves paying off the smallest loan first, then moving on to the next one.
The snowball method can be more costly than the avalanche method, because you might pay more interest over the long run,” Gallegos said. He added that, while the snowball method may cost more, it’s a better fit for individuals who aren’t motivated to pay off their debt.