Now that the recession has begun to improve, you may finally be seeing light at the end of your own financial tunnel. During the worst of the recession, you probably built up more debt than you want to continue to carry. You have car loans, credit card debt, a home loan and student loans. Which should you pay off first?
First stop taking on new debt. Do not buy things you cannot pay for in cash. Next, tackle the project systematically. Review your debts, pick one to target for payoff, and start making big payments to it. By all means, keep your other debts current but put all of your extra money toward the first bill. When the first debt has been paid off, pick your next target debt. Add the first payment amount to the second one. When that debt is paid, do the same again. Because you are adding all of the early payments into the payments for the following bills, they snowball one into the other making the last bills go much faster than the first ones did.
How do you decide which debt to pay off first? There are several factors to help with that choice. A common guideline is to choose the debt with the highest interest rate. Another way to choose is to pick the smallest debt first. Getting out of debt for most people will be a long-term project. Having a small victory early in the process helps keep up morale.
By the same logic, targeting your home mortgage first would probably not be the best choice. Waiting a couple of decades for that first victory would try anyone’s patience. The mortgage can be the last debt in the list and can even come after the emergency fund and college savings. A mortgage loan is generally a very low interest loan with tax advantaged payments.
What about student loans? If you are like the average graduate of a four year college in recent years, you have over $25,000 dollars in student debt to repay. Student loan debt now tops $1 trillion in the U.S., which is more than our national credit card debt.
By the standards mentioned earlier, you might want to let student loans come after the other debts in your list. Certainly some student loan payments have tax deductions associated with them. Certainly most student loans have lower interest rates than most credit cards do. However, student loans have some dangers associated with them that credit card debt does not have.
Student loans are extremely difficult to discharge in bankruptcy, and if they go into default, there are no restrictions on their collection. If a student loan goes into default, between fees and penalties, the debt can end up many times its original size and will never die. The statute of limitations does not apply to collecting on student loans. Student loan collectors can even garnish social security checks.
The consequences of student loan defaults are so much more serious than any other loan default that paying them off early in your getting out of debt sequence might be your wisest choice. This is especially true if there is any chance you might not keep your current level of income.
Even when all of the debts are paid off, keep going. Once you can stop paying other people, start paying yourself. Send those payments to a savings account to until you have a cushion of six months living expenses. After that, start funding retirement accounts or college funds for your children.