Prioritizing debt by interest rate.
First, you'll pay off your balance with the highest interest rate, followed by your next-highest interest rate and so on. As you work your way down the list, be sure to continue making the required minimum payments on all accounts.
Generally, it makes the most sense to pay off the highest interest rate loans first, because over time it means you pay out less in interest.
Most people agree that unsubsidized federal loans should be the loans that get paid off first before subsidized loans.
Option 1: The “high-interest first” strategy
Paying off high-interest debt first is commonly referred to as the avalanche method. This involves making the minimum monthly payments on all of your credit cards and loans, but putting every extra penny you can toward the card or loan with the highest interest rate.
Pay Off High-Interest Loans First
With this approach, you pay off your loans from the highest interest rate to the lowest. You make the minimum payments on each balance except the highest-rate loan. You also make an extra monthly payment based on how much you can put toward the debt.
The Best Ways to Pay Off Debt
Debt consolidation, the debt snowball method and the debt avalanche method are some of the best ways to tackle debt, especially if you have high-interest credit card balances.
In general, federal loans have stronger borrower protections and lower interest rates than private student loans (regardless of what your federal loan may be called). Because of these benefits, you should focus your efforts on paying off your private loans first.
So the goal is to pay down the principal as quickly as possible. If you send more than the amount due each month, the extra funds are first applied to any outstanding interest and the remaining amount goes directly toward paying down your principal.
Getting ahead of your debt is generally a smart move; however, if it comes at the cost of avoiding other debt, or overshadowing other benefits you may be receiving, it could set you back in the long run.
With the debt avalanche method, you order your debts by interest rate, with the highest interest rate first. You pay minimum payments on everything while attacking the debt with the highest interest rate. Once that debt is paid off, you move to the one with the next-highest interest rate . . .
Comparing two options side by side is the best way to figure out which is the better deal. Compare how much cash you need to have at closing, the monthly payment, and how much interest you pay over the time you expect to be in your home.
Tackling your credit card debt first will also give you a better shot at improving your credit score. Revolving credit is highly influential in calculating your credit utilization rate, which is the second biggest factor (after payment history) that makes up your credit score.
Payment history is the most important factor in maintaining a higher credit score as it accounts for 35% of your FICO Score. FICO considers your payment history as the leading predictor of whether you'll pay future debt on time.
Key Takeaways. Paying off a loan may lower your credit score, but if you practice good credit habits the effect will be minimal. Paying off a loan early can reduce your debt-to-income ratio, which can benefit your credit. Your credit score is based on a number of factors, like payment history and credit utilization.
Ignoring interest rates can be a big mistake when paying off debt. High-interest debt can cost you more the longer you have it, so it makes perfect sense to pay off the loan with the highest interest rate first. The nickname for this tactic is the “avalanche method.”
The amount of money you're borrowing is known as your principal. The interest is the cost you pay for borrowing money. Interest and fees are generally paid before your payments go towards your loan's principal.
A subsidized loan doesn't start accruing interest until you've graduated and you're out of deferment. Unsubsidized loans, on the other hand, start gathering interest as soon as you borrow them. It makes sense, then, to work on paying off these loans first.
Initially, most of each loan payment will be applied to interest charges, not the principal, so the loan balance will decrease slowly. There may also be interest that accrued during a deferment or forbearance. This interest must be paid off before the principal balance will decrease.
If the interest rate is the same, it doesn't matter which you pay off first as far as the math goes. That's the commutative property in mathematics in action. Psychologically, paying off the smaller debt first tends to better because you get a win sooner to keep you motivated.
If you qualify for subsidized loans, use them first. They are your cheapest option, since the government pays the interest while you're in school.
Pay off your most expensive loan first.
Then, continue paying down debts with the next highest interest rates to save on your overall cost. This is sometimes referred to as the “avalanche method” of paying down debt.
Those will become part of your budget. The 50-30-20 rule recommends putting 50% of your money toward needs, 30% toward wants, and 20% toward savings. The savings category also includes money you will need to realize your future goals.