April 10, 2013

Which Debt Should You Pay off First?

I recently saw someone asking what debts they should tackle first.   When you are deciding which order to pay off debts you should generally pay off the highest interest rate debts first.   But not all debts are created equally even if the interest is the same.    Some debts are worse to carry due to their nature and there are other concerns than just the interest rate.

Below I  list what I think are the priority order of debts you should repay in general.  I start listing the worst kinds of debts and then move on to the lower priority debts.   This is not meant to be any kind of hard fast rule or anything since every situation is different in various ways.   This list of debt priority is more a generalization and there will be exceptions.

Here are what I think are the priorities for repaying debts :

Worst kinds of debts :
Loan sharks -  This item is mostly tongue in cheek as I would hope you don't borrow money money from the type of people who would break your knee caps.   But in case you do owe money to any criminal types its a good idea to pay that back and not borrow from them again.
Court judgements or fines - Any time a court tells you to do something its in your best interest to do what they said.  We don't have debtors prisons in the US but courts still have a lot of power to punish you for not obeying them, even if its dealing with with just paying parking ticket or a debt judgement.

Payday loans - Payday loans, car title loans or any other short term debt will generally have the worst interest rate terms. 
Pawn shops - While they may be a bit cheaper interest than payday loans the pawn shop loans generally carry collateral and you can lose your property if you don't repay within the terms of the loan.
IRS Tax debts - The worst thing about tax debts to the government is the power that the government has to collect the money.   If you do owe the government taxes then you should work with them to setup repayment terms.    The IRS isn't the worst lender out there and their terms are often better than you'd think. 

State or local tax debts -   State or local governments are pretty similar to IRS debts in general.  You want to get that paid off so the government doesn't punish you.   I don't know how generous the terms are for state/local levels and they may vary drastically.
Buying stock on margin -

Debts to friends and family (maybe) - I list this one because sometimes borrowing money from friends and family can lead to very uncomfortable situations and strain the relationship.   You should do your best to pay back relatives and friends as soon as possible.   Even debts with fair terms between relatives that trust one another can end up harming the relationship if you fail to pay back the loans.   The amount of interest often doesn't impact this situation as much, its more the fact that you owe them money  and they are worried about getting it back.   But this situation varies based on the friends or relatives.  Some relatives and friends don't worry as much if they know they can trust you.  For example if your rich uncle loans you some money to go to college then they may not worry much if you don't pay them off right away.  But even there its not good to abuse the situation and you should make payments as required.  If you do borrow from people you know then make sure to sign a promissory note and pay them interest, that will help the situation.
401k loans -   I am not a hater of 401k loans, however they have disadvantages.  The key problem with a 401k loan is that usually if you lose your job you have to pay back the balance immediately.   If you can't do that they cash your 401k out and pay it off for you which then incurs taxes and a 10% penalty.  This is a real risk with a 401k loan and you should pay them down to avoid that happening. 

Higher interest debts: (over 7%) 
High Interest Credit cards - Typical credit card interest is in the 15-30% ballpark.   That is among the most expensive debt you can carry.   If you can't pay off a credit card then you may be able to do a balance transfer to get a good promotional rate on another card.

Paying down PMI on a mortgage - Usually the amount of PMI on a home loan is going to cost you effective interest rates that are in the ballpark of 10%.   That includes the interest on the mortgage itself plus the PMI.   You can figure it yourself by taking the (annual PMI cost ) /  (amount of equity your short of 20%) + mortgage % rate.
Higher interest student loans - Student loans follow you for life.   You can't get rid of them in bankruptcy (with rare exception).    Many student loans carry interest rates of 6.8% which is a relatively high rate but not excessively high.  But some student are higher and can exceed 10%.

Car loans - An auto loan isn't the worst kind of debt and worst case you can sell the car.  But on the other hand you generally don't want to lose your means of transportation.  Auto loans may have higher interest rates as well, and some of the worst ones are over 10%. I've occasionally heard of them hitting the 15-20% level.

Higher interest personal loans & peer-to-peer - You may be able to get a personal loan from a bank or credit union without collateral.   These are often better than credit cards or payday loans and the like, but still often carry fairly high interest.   My credit union offers rates around 8-12%.  In this day thats a very high interest rate.   You can also get personal loans from peer-2-peer lenders like Lending Club or Prosper.  I'd put those in a similar category.

Floating rate or promotional rate debts
Adjustible Rate Mortgages (ARM) - An adjustable rate mortgage may give you a very low current interest rate.   Amerisave says I can refinance my house to a 5 year ARM at just 2%.  Sounds great.  However when interest rates go up in the future that rate will climb.   That loan can go up 2% a year and could hit 7%.  If that happens your monthly payments could nearly double.    Its not easy to pay off a home mortgage for most of us given that this is usually a very large amount of money, but with a mortgage you usually have the option to refinance an ArM into a fixed rate loan.  Even if your house is under water and you owe more than its worth the governments HARP program can help you refinance to a reasonable fixed rate.
Home Equity Line of Credit or HELOC - A home equity line can be had for fairly cheap right now, assuming you can get one.   The rates are currently pretty low since they are tied to indexes like LIBOR or the prime.  For example my credit union offers loans as low as prime + 0.5% and that is about 3.75% right now.  But that credit line is variable and could go as high as 17%.
Temporary low interest promotional rates - You can often make purchases of furniture or other major home items with 0% deals.   These promotional rates carry a big 'gotcha' in their contracts.  If you do not pay off the debts in full before the end of the promotional period then they levy high back interest for the entire term.  Make sure to read the terms of any promotional deal and pay them off within the term to avoid any penalties.

Medium rate debts (5-7%)
Student loan debts - Depending on when you got your loans and the exact terms, it is possible to get student loans with relatively moderate interest rates.  These aren't a extremely high priority but certainly worth paying off to avoid the interest costs.   Plus as mentioned earlier you really can never get out of student loan debts so you should pay them off when you can.

Lower Priority debts

Rental / Business loans -  If you have debts versus collateral that is used for business purposes then that kind of debt is not generally as high a priority as loans against your personal property.   For example a mortgage on a rental is not as high priority as a loan on your own personal residence.   Worst case if you lose the rental you simply lose an investment property, but if you lose your primary residence then you may be homeless.     You should however of course try to pay down or refinance higher rate loans.   Today is a great time to refinance a rental property.   As long as your rental loans are low interest and you're cash flow positive then I see no reason to need to pay them off fast.

Low fixed rate debts (under 5%)

Personally I don't worry much about paying of low interest debt fast.   If you have a fixed loan and the interest is low then this is not a high priority to pay off fast.    If your debts are in the 5% or lower level and are fixed and have no other risks or problems then these should be your lowest priority of debt to repay.   In some cases I would not even worry about paying the debts off faster than the term of the loan.   For example with mortgages down as low as 3% level I see no need to pay those off fast.  Inflation will grow faster than that and in a few years you can probably get over 3% in various safe investments.

Keep in mind like I said above, this is pretty general in nature and theres always exceptions since everyones situation will be unique.

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