According to NerdWallet, paying down debt in the next 10 years is a top financial goal for 58% of Americans. By understanding what to tackle first, reducing your debt balance is possible.
But before you start chipping away at your balances, it can be good to strategize. Which debt should you pay down first? And why?
First, categorize your debt
There are two types of debt: debt for appreciating assets and debt for depreciating assets.
When you borrow money as leverage to get a potential return or invest in an appreciating asset, you create “good” debt. The interest rate is usually lower, so this type often costs less.
Student loans, for example, are appreciating assets because they provide the financial leverage needed to further your education. A mortgage is another: Taking out a home loan lets you purchase an asset that typically increases in value over time.
The other type of debt is when you borrow money for a depreciating asset, like material possessions. This debt often carries a high interest rate. Credit card debt, personal loans, and payday loans are good examples.
An auto loan also may be categorized in this camp since a car is a depreciating asset. But auto loans typically have lower interest rates than something like credit card debt.
Next, prioritize what debt to pay off
The kind of debt you have should influence the way you pay it off. Since debt for depreciating assets offers you no opportunity to build wealth — and it usually costs more money to keep a balance due to high interest rates — it typically makes more sense to pay off those balances as soon as you can.
Good debt, like for a mortgage or student loan, helps you leverage your cash flow by paying for an appreciating asset over time instead of all at once. This debt doesn’t cost you as much because of the lower interest rate usually associated with it, and it gives you the ability to use some available cash for other priorities. Make your payments on time and in full, but beyond that, you can consider using your cash in other ways to reach your financial goals.
Beyond prioritizing high-interest payments, it can come down to personal preference when it comes to what loans to pay off. If your student loan and car loan have the same interest rate, but you’re eager to pay off your student loan since you’ve been working on it for seven years, it may make sense to put extra payments toward that. Just make sure it’s not at the expense of paying your car payment in full each month.
Understanding what kind of debt you have and how it impacts your repayment priorities is an important first step to managing your debt, putting a repayment plan in place and taking control of your finances.