This post comes from personal finance blogger Jason Bushey.
I recently received this question from a Money Talks News reader:
I’m (finally) devising a plan to pay off my existing debt. The bulk of my debt is made up of student loans and credit cards. The student loan debt is fairly straightforward since it’s just one loan, but the credit debt is spread across three different credit cards to the tune of $12,000. Can you advise on which debts I should pay down first? — Kerry W.
Organizing a plan to pay down debt is the first step toward getting out of the red and into the black, and it’s nice to hear from readers like Kerry who are eager to turn their finances around.
There are a lot of ideas out there about how to prioritize debts. Some personal finance writers will tell you to pay down the smallest debt first. While getting a small debt paid off quickly will serve as a nice early win in your effort to pay down debt, I think it makes more sense to pay down the debt carrying the highest interest rate first.
The higher the interest, the harder it is (and the longer it can take) to pay off debt. Paying a 20 percent, 25 percent or even close to 30 percent APR makes paying down your balance extremely challenging because so much of your monthly payment is going to interest. Cards that carry interest that high are often retail-branded cards, or they might be the first unsecured cards we opened long ago in hopes of building credit.
Whatever category of card they are, with interest like that you’ll want them paid off as quickly as possible.
Interest isn’t the only reason you’ll want to ditch that credit card debt first. If you have other kinds of open debts – be they student or car loans – it may actually help your credit score long term to pay those bills off as they come due rather than rushing to pay them off quickly. Sounds crazy, right?
Here’s why: Mortgages, student loans and car loans are installment loans and have an expiration date. Assuming you make each payment on time and on schedule, you’ll pay off the loan by that date. Once that happens, the account is reported as closed and will eventually fall off your credit reports. Paying off an installment loan early expedites this process, meaning the quicker you pay it off, the shorter it will remain a positive indicator for your credit scores.
Of course, paying them off faster will save you money. But because the annualized interest rates applied to installment loans are by and large much lower than those applied to credit cards, it makes sense to pay off your credit card debt first.
Plus, paying off a credit card balance does not close your account unless you request it to be closed. So even though you no longer carry a balance, that account (and the credit line attached to it) is still being reported to the major credit bureaus.
So you see, it’s really a win-win to pay off your credit card debt – and more specifically the credit card with the highest interest rate – first. Not only will it eliminate costly interest charges, but you can retire the debt and still have the benefit of those credit lines in your credit reports — contributing to a healthy credit score.
For consumers like Kerry, my advice is to pay down the debt with the highest APR first while keeping all of your other open accounts in good standing. Keep those old credit cards open once you pay them off so that you can continue to benefit from their good status with a higher credit score.