The importance of debt prioritization
Credit is a fact of American life. Whether it's a credit card, mortgage, car payment, or even a business needing extra funds to make a new product, almost all of us look to various forms of borrowing to get what we need and want.
The thing to remember is that not all credit is bad. It's how that credit is treated, prioritized, and paid off that makes the difference.
It can be difficult for the average consumer to organize debt effectively—confusion about interest rates versus annual percentage rates (APR), not knowing payoff amounts for certain debts, and the need to balance monthly payments with long-term financial goals can make the entire process too time consuming and hard to grasp.
There are some strategies, however, that anyone can use to prioritize debt and start conquering that mountain of bills. Which ones you use will depend on your own financial status, your goals, and other such factors. But regardless of the strategies you employ, the key is to start now and start making sense of your debt.
Also note that in this article, "debt" includes more than just loans or credit cards—it's any revolving, recurring bill you have each month. For this reason, utilities and even rent are classified as "debt."
Paying off debt
Which one you choose will depend on your current financial situation, and mixing and matching methods from each is also effective.
With this strategy, you look at the total amount paid throughout the lifetime of the obligation, including interest and annual fees. For this reason, credit cards should be at the top of the list when using this strategy.
Using the calculators at www.pioneerservices.com/calculators, one can see why credit cards should be paid first when using a long-term strategy:
These numbers clearly show that making minimum payments on your credit cards costs an enormous amount over the long haul. For this reason, any long-term strategy should focus on getting these debts paid off first and foremost.
After you get your credit cards taken care of, the next step is to order your debts not necessarily by the highest interest rate, but by the longest term—or length—of the debt.
For example, say you have two loans, one with an interest rate of 15 percent and six months left to pay on it, and another with an interest rate of 10 percent and 24 months left to pay. In this case, it's a better long-term decision to concentrate on paying off the 10 percent loan first. This is because over time, that 10 percent loan will cost you more in interest charges than the 15 percent loan will in the next few months.
So organize your debts looking at which one will cost more throughout the life of the debt, and focus on paying those first.
The month-to-month, or cash flow, strategy
It's best to use this strategy only until you can make all of your monthly payments—after that, it's best to switch to a longer-term solution.
The first step is to list all of your monthly bills by ease of payoff. This could mean the smallest amount you owe, or the debt with the shortest time until it's paid in full. To use the two loans in the long-term plan above, in this case you would pay off the 15 percent loan due to end in six months first, then move on to the next.
The advantage to this method is that you can see progress relatively quickly, thus motivating you to stick with the plan. After all, having just one less bill can be like having a huge weight lifted off your shoulders, no matter if the bill was small.
The major disadvantage is that if you have a lot of credit card debt, it usually puts that debt lower on the priority scale, meaning you will pay more in interest over the long run.
If you find yourself consistently using the month-to-month strategy, you may want to consider some type of debt consolidation loan. Doing so can reduce your monthly payments while also paying off longer-term debt (such credit cards, especially if you only make the minimum payment) in a shorter amount of time.
The interest-rate strategy
If you use this strategy, remember to use the effective interest rate (EIR). The EIR takes into account any tax deductions you may get on the debt, such as the deduction you receive on mortgage and student loan interest. Since interest payments on these debts are tax deductible—depending on IRS eligibility rules, such as income and the type of residence—the EIR is often lower than whatever is stated on the paperwork.
Prioritizing your debt can be difficult, and figuring out which strategy to use in doing so can be complicated, depending on your debt load, income, family situation, and a whole host of other factors.
But it's an essential step in any financial plan and, better yet, can actually make you feel much better about your finances—seeing all your bills and exactly what you owe gives you a sense of control over the situation. And as with any financial plan, the most important thing is follow through. Picking a strategy and organizing bills won't do much if you don't use that strategy effectively and consistently.
So pick your plan, get your debt prioritized, and start down the road toward a secure financial future today!
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