While common sense seems to dictate that you pay off your highest rate debts first, in reality you may want to pay off the debts that have the lowest interest rates first. This is because lower rate debts tend to belong to lenders that have you by the throat when it comes to future recourse.
When you have several different types of debts and your income isn't quite keeping up with your total expenses, it can be tough to figure which debts to pay first. Ignoring high priority debts and focusing on less important ones may ultimately leave you in a worse situation than you were before. It's often helpful for many people to have a table that lists their debts in order of highest priority to lowest.
- Secured Debts
- Debts for Which Wages Can Be Garnished
- Services That Require Continued Use
- Unsecured Debts
Your secured debts, which could include your home or car, need to be at the top of your priority list. They have assets backing them up and can be repossessed or taken away. Depending on your personal situation, filing for Chapter 13 bankruptcy may eventually be an option that will allow you to reorganize your debts, restructure mortgage payments and force a lender to accept delinquent payments, but that will also destroy your credit and should be viewed as a last resort. Until that happens you need to prioritize the assets that allow you to keep working first and foremost.
Debts for which wages can be garnished should be next up on your list. These include IRS, student loans, and child support payments. If these debts are not paid on time, they often come directly out of your paycheck. Skipping out on child support could also result in serious penalties including prison time.
Services that require continued use, such as utilities or a doctor, should be next on your list. If you don't pay your doctor, they probably won't see you again. Excessively late payments on utilities or a phone bill typically result in a penalty that is a percentage of the total cost of your bill. However, many utilities will accept a partial payment temporarily and allow you to keep your services turned on.
These three debts are the highest priority ones. Once they've been cleared, you can begin to focus on unsecured debts like credit cards. Unsecured debts are those with no assets backing them up and cannot be taken away. It may be a hassle to deal with a collector who constantly calls you, but these lenders do not have the right to repossess your property, and are more willing to negotiate when it comes to debt forgiveness. If you find yourself in a situation where you can't cover your credit card debt after paying for the three other debt types listed above, then consider finding a balance transfer offer that will allow you to go a year or more without accumulating further interest.
The interest rate hierarchy
For the very same reasons that you should prioritize debt in this order, interest rates tend to increase in the same order. Your secured lenders have confidence that they can repossess your property if you fail to pay, while your utility company is fairly certain that you can only go so long without electricity. Meanwhile, your credit card company knows that they are last in line when it comes to collecting money from you, and therefore require a higher return on their loan. To mitigate this problem, don't get lured in by rewards credit card offers, but instead stick to low APR credit cards that will keep you from getting buried under rapidly accumulating interest.