Order of debt reduction?

BillR · #1 (**permalink**) 06-07-2007, 11:34 AM

So, I've browsed around here quite a bit in the last few days and I'm trying to find a good guide on the order in which you should reduce debt.

I am fortunate enough to not be someone in dire straights - I am comfortable financially right now but I've had big changes lately - my wife quit her job after we had our first child. This was planned - and we can easily survive.

I don't want to survive though - I want to thrive. I think she and I can do that too if we plan well.

We don't have too much crazy debt - mortgages, LOCs, and cars pretty much.

What I am curious to see is some sort of order of debt reduction. Every article I've ever read concentrates on the credit card debt, etc up front - we don't have any. I'm more interested in knowing things like an authoratative guide on what order to pay things on.

If you read my other post you'd know I'm struggling with that issue right now - is it better to pay off a LOC or a car of the same debt amount? I have no idea.

I'd appreciate any insight/links people have to articles on this.

Dru · #2 (**permalink**) 06-08-2007, 11:17 PM

There are two schools of thought when it comes to order.

1- pay off the highest rate first to minimize cost. Pay minimum payments on everything else until that one is gone, then move on to the next highest rate.

2- Pay off the lowest balance first. This gives you the reward of seeing progress sooner, and aids in motivation.

In both cases, you "snowball" the money. As one payment goes away, you add that payment to the next item, and so on. Your monthly expense remains constant until all debts are paid.

BillR · #3 (**permalink**) 06-09-2007, 02:32 AM

Motivation really isn't an issue - I could pay all of them off but I want to remain fairly liquid right now for other reasons. I've been fortunate that way.

I appreciate the insight though - the real question is "if all else is equal, which is better to pay off first?"

Dru · #4 (**permalink**) 06-09-2007, 01:28 PM

If everything is equal, then it really doesn't matter which one.

If rates and balances are equal but one has a higher payment, pay that one first to free up cash flow.

This is like choosing which box of cereal to have for breakfast. What mood are you in? Either way you will get fed and be happy. Just make a choice and move on to something relevant.

Amendment: Typically it is recommended to pay off secured debt before unsecured debt. This is mostly a rule that benefits you in case of a bankruptcy. Unsecured debt is removed through BK, while secured debt becomes part of the restructuring plan. This is one reason a debt collector will suggest borrowing against your home to pay off the credit card, and the same reason you should avoid doing a debt consolidation with your home, which now secures all your debt.

Debt Elimination Nation · #5 (**permalink**) 09-12-2007, 04:27 PM

I would think about it like this...

look at the underlying asset the debt is associated with.

Car loan... depreciable asset and very important to pay that off ASAP!!!

loc - on what? house... appreciable asset so there is really no rush to pay this off. You would want to pay this off before you make extra payments on the mortgage itself.

If the LOC is unsecured then you want to pay it off before the car probably. I would venture to guess that it definitely has a higher interest rate.

If the asset that the debt is associated with is something that appreciates in value then I would save those to the very end to pay off... if even pay off at all because that is good use of leverage.

If the asset is something that depreciates in value then pay it off ASAP... and in this case you want to pay off the higher interest rates first if you can!

FredS · #6 (**permalink**) 09-13-2007, 10:49 AM

Quote:

Originally Posted by BillR

Motivation really isn't an issue - I could pay all of them off but I want to remain fairly liquid right now for other reasons. I've been fortunate that way.

Quote:

Originally Posted by BillR

I appreciate the insight though - the real question is "if all else is equal, which is better to pay off first?"

The suggestions already provided are great. Here are a couple more ideas.

First, can you still draw on the LOC and how long until your “other reasons” will require funding? If you can still draw and it will be some months until you need funds then consider paying off both now. Then, when the time comes, use the LOC to fund the “other reasons”. In the mean time you will save the interest payments on the LOC. During this time you will also be able to put funds back into your liquid account. Thereby reducing the amount you draw from your LOC.

Second suggestion. If the LOC is in the form of a home equity loan then and you can deduct the interest then pay off the car first. This assumes that the interest rates for the two loans are about the same.

Best of Luck,

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