For many with a less than stable sense of financial security, Debt could be seen as a dirty, four-letter word. There’s just something so offensive with the word that hearing it next to your name can make you cringe.
But debt is something that is not so insurmountable that you can’t clear it off within your lifetime. In some cases, having some debt that rarely approaches a debt ceiling in your credit report history can do a lot of good for your credit score (but this is a topic for another post).
Either way, you’d rather deal with your debt as quickly as possible. Here’s the problem: which one should go first? Let’s discuss.
Some Preliminary Considerations
Before anything else, it is important to establish one’s overall strategy towards debt management. The reason for this is quite simple: not a lot of people have one.
Thus, a task that needs a lot of concentration and dedication is made 5 or 10 times harder by a lack of understanding and preparation. As such, there are a few things that you have to do first.
First, find some way to reduce your debts across the board or at least at the ones that have the biggest figures. You could also look into consolidating your debts as this pools all your obligations into one account without hurting your credit score in the long term.
There are also other debt-reducing strategies that you could avail of such as personal loans or ask if there is an interest rate reduction option for your credit cards. These are some of the things that you should at the very least have considered in dealing with your debt.
Second, and perhaps the most important, you have to understand that there is more than one way to efficiently pay off your debts. Different strategies work differently for, well, different persons. This all depends on your resources, your mentality, and, of course, the kind of situation that you are in.
So, with those out of the way, which of the debts should you pay off first? To start answering that question, it is best that we come up with a scenario.
Let us say that you currently have 3 kinds of debt which are as follows:
So, which one of the three should you deal with first? Let’s look at the options.
Strategy #1: By Balance
The premise of this strategy is rather easy to understand. Simply put, you place your debts with the smallest balances first and pay them accordingly. You might have also heard of this strategy called by another name: The Debt Snowball Strategy.
So, going back to our example, you can order your debts like this:
This is, of course, if you have yet to start paying off your debts. But what if you only have £10,000 remaining balance of the £130,000 mortgage? The order would have changed and, now, you would prioritize taking that debt off your list.
The benefit of this strategy is also obvious. By focusing on your least troublesome balances, you can quickly clear off items in your list. Thus, even if you have 3 small debts and 5 large ones, totaling 8 items on your debt list, eliminating the 3 means that your list just got cut in a short period of time.
The only problem here is if the difference in amount between your small and large debts are quite far and wide. If you managed to tick off your smaller debts amounting to no less than £10,000 but still have to deal with large ones totaling £200,000, the changes in your credit report score are rather insignificant.
Strategy # 2: By Interest Rate
As with the previous strategy, this one requires you to make the minimum payments while clearing off the first one at the top of the list. But, instead of the remaining balances, you would look at the interest rates that were imposed on them.
The logic for this is seemingly flawless. Theoretically speaking, by dealing with the debt with the biggest interest rate, this should allow you to deal with the lowest overall total payments. In essence, you have to pay less while clearing off considerable chunks of your total debt.
As such, your debt list could look like this:
The drawback here, however, is that this strategy is utterly dependent on how your debts are structured. Some debts with low interest rates can take a while to get paid off fully especially if the balance is still huge. As such, your debt management strategy could feel like a slow burn.
Strategy # 3: By Credit Card Limit
As this strategy simply orders you to order your debts by their credit limit, it goes without saying that your credit card debts will take topmost priority here. Your more traditional debts will come later on in an order of your choosing.
You may use this strategy if your overall approach or goal is to maximize your credit for the next year. For instance, if you want to get better chances of securing a mortgage by getting the highest possible credit score for your case, then you should start paying off the debts with the highest credit limits first.
Why would this help you, you ask? Remember that one major aspect of your credit score is credit utilization which is the percentage of the overall credit limit that you are using right now. Your score can drop if that percentage is high and recovers if it is low.
Of course, you’d focus on the one’s that are nearest to the credit limit or beyond it. As such, your list could look something like this:
The drawback here is that the percentage of your credit limit changes regularly every month which means that the list could change from time to time. This is quite true especially if it takes you a while to clear off an item in your debt list.
Strategy # 4: By Severity
In this strategy we take a look at which debts are going to impact you the most personally, not necessarily only regarding the interest. Here we means things like potentially not satisfying them could mean losing your home, having your car taken away or constantly being contacted by debt collection agencies.
If you’re in the situation where you have more debt outgoing than money you’re bringing in then the situation is indeed a tough one. You’d want to repay the most expensive capital, whilst at the same time ensuring you’re covering your mortgage/rent but also you are keeping those collection agencies at bay. They can be a massive irritant in your life, and make homelife miserable.
Your list might then have the default debt at top and the company who appears lenient with you to be near the bottom with a more minimal payment.
Delinquency vs. Default: Which Should You Go With?
Aside from your order of prioritization, you should also consider the timeliness of your payments. In fact, you might have already missed some payments for your debts. As such, the question you could ask yourself could be “Should I wait to get the right funding to pay off my debts or do I pay for them incrementally?”.
To answer that question, it is important to understand the distinction between a Delinquency and a Default. Delinquency, for starters, is what happens when you miss a payment for a particular financing option such as mortgages and credit card balances.
For example, you fail to make a payment on your credit card by two days after the due date. Your account remains on delinquent status until you pay that amount.
Default, on the other hand, is when you not only fail to repay your loan but also fail to honor your succeeding obligations arising from that failure. For instance, you issued a cheque for the credit card payment you missed. However, you failed to pay the amount on the date you promised. After a period spanning no more than 1 year after you still haven’t paid or started to pay the balance, your entire account will be marked as Default. In some cases, if you haven’t run your account well, the loan company may issue a default after, say, 3 missing payments.
Which One is Worse?
Do not get the wrong idea. Defaulting or becoming delinquent in your payments is something that no one would recommend. The reason for this is that both can affect your credit score negatively.
Delinquency, however, is considered the lighter offense of the two. If your account becomes delinquent, all that you need to do is to pay the overdue amount plus any fees, and your account will return to normal after that. There might be some small notifications in your credit history to reflect these times that you became delinquent but their overall effect on your credit score is negligible.
For default accounts, however, the problem is a bit more complicated. If you defaulted, any leeway that the lender gave to you is no longer available, including access to your account and you’d have to pay the full amount plus fees and interest as soon as possible.
And as far as your credit score is concerned, defaults can inflict a lot of damage on it the longer it remains unpaid. Depending on the amount you have to pay, you can expect for your score to go down by double digits in the next report. This would mean that you would have a harder time borrowing money in the future, getting approved for an insurance policy, or even renting an apartment.
Due the reasons above, it is best that you pay on your delinquent accounts quickly before they are elevated to Default status. As such, it would be better to pay off in increments to show to the lender that you are doing your best to clear off every debt that you have.
That does not mean, however, that you cannot recover from multiple delinquent accounts. A debt management strategy that focuses on prioritization and consistency should take off huge chunks of your overall debt and clear off several items on your debt list. If done right, you should see considerable improvements in your score in the next few credit reports or so.
So which of the strategies above should work? That really depends on you. What you have to remember is that a lot of strategies in personal finance are dependent on your overall goals and where you want to be in next 3+ years.
If you are the one that wants to see immediate changes in your credit score, then the Balance method is ideal. If your goal is to make your score recover quickly so you could avail of crucial financing options like loans and mortgages, the percentage or credit limit would work best.
If you are the one that wants to pay marginally less in interest rates over time, then the Interest Rate method is a good choice.
And if you want to ensure you don’t fall any further backwards whilst containing your current exposure then in more extreme circumstances look at the severity method.
The point is that all of these strategies are equally viable methods. It is up to what you want out of your debt management strategy that determines which route you should take.
And, despite whatever strategy you choose, you must complement it with your commitment to the plan. Consistency and speed in delivering payments to your obligations will help you clear off your debts, regardless of what you prioritize first over the others.