Which Debt To Pay Off First

Congratulations! Deciding to pay down your debt is an excellent step toward controlling your finances.

Begin by getting organized. It's important to prioritize which debts you pay first. Debts often grow at different rates and have different default consequences. Paying your limited cash to the wrong debt can put you in deeper debt than you started due to interest and penalties that may accrue on your other loans. Below, you'll find information to help you prioritize your debts.

Know What Kind of Debt You Have

Gather your financial documents and bank statements. Identify the types of debts you have and the consequences of defaulting on each obligation. Most consumer debts can fit into one of the following categories:

  • Secured debt: The lenders for secured debts have an ownership interest in your property. The most common types of secured debts are mortgages and car loans. When you can't keep up with loan payments, the lender can repossess the collateral property or initiate foreclosure proceedings.
  • Child support: While every state has different enforcement policies, failing to pay your child support obligation has serious consequences. You can face the loss of your driver's and professional licenses, seizure of tax refunds and wage garnishment, and even criminal charges. Child support is rarely reduced, although many states may modify monthly payments or create unique payment plans. Child support and alimony are priority debts that a bankruptcy court cannot discharge.
  • Student loans: Many student loans offer flexible repayment plan options. Depending on your financial situation, you can apply for a forbearance or deferment. If you file for bankruptcy, the court will not discharge student loans without showing significant financial difficulty, known as undue hardship.
  • Overdue utility payments: Many utility companies will tolerate two or three missed payments, but the company may cut you off. Defaulting on utilities can make it difficult to obtain service at a new residence.
  • Unsecured debt: This category includes almost every other kind of debt, such as credit cards, medical bills, and personal loans. Lenders may increase your interest rates, charge late fees, or sue the delinquent borrowers. Unlike secured debts, unsecured debts aren't secured by property. This means lenders have nothing to repossess should you fail to repay the debt. While repaying your obligations is important, these debts are a lower priority. Bankruptcy generally discharges non-priority debts.

Review the penalties for not paying these debts. While too much debt is not good, you sometimes must choose which debts are the most serious and have the worst consequences and tackle the rest later.

Which Debts Should You Pay First?

There are many methods for paying down debt. Choose one that works for you and your budget. Debts often grow at different rates and have various consequences for missing payments or defaulting. To get a clearer picture, list your debts and loans, interest rates, and possible default implications.

For example, paying down the wrong debt can put you in deeper debt. Debt can increase due to the interest and penalties that may accrue on your other loans.

Take the time to consider and calculate how you want to pay down your debts, including:

  • Paying on loans for everyday necessities
  • Fulfilling your legal obligations
  • Choose a plan for paying off debts
  • Paying your deferred loans

You can find a recommended order for paying off debts below.

1. Pay for Necessities

Many borrowers have fallen behind on mortgage payments, car loans, or utility payments since the beginning of the COVID-19 pandemic. If you miss too many of these payments, creditors can foreclose on your house, repossess your car, or shut off your utilities.

However, most of these loans carry lower interest rates than other types of consumer debt, such as credit cards. This lower rate means your "debt load" on these loans grows slower than your credit card debt.

If you're not going to be filing a bankruptcy petition, consumer debt and bankruptcy lawyers sometimes advise making the minimum payments necessary to keep your house, car, and utilities on while working on other debts.

Borrowers can often negotiate with banks to establish a new payment schedule or reduce the loan's total amount. Of course, if you're current on these debts or have already established an alternate payment schedule, staying on course may be the best option.

If you are delinquent on payments, some creditors or lenders may choose not to apply your new payments to the debt. If you think this is happening to you, immediately speak with an attorney. You want payments to apply to the debt, not to new money owed. Consider setting up a separate savings account to keep your payments in until you are sure payments are correctly applied. Then, you can pay your overdue amounts in full when the payments get resolved.

2. Fulfill Your Legal Obligations

Consider the money you legally owe others once your day-to-day debt has a plan.

Child support and tax payments are serious obligations. These are generally not discharged in bankruptcy. So, you will face these debts no matter what option you choose. Most child support and tax collection agencies will work with you to create a payment plan that fits your budget. If you have a payment plan worked out, it's best to follow it exactly.

Failure to make child support or tax payments may have devastating consequences, including:

  • Raised interest rates and possible penalties (tax debt)
  • Suspension of driver's and professional licenses
  • Wage garnishment (taking money from your paycheck before you get it)
  • Fines
  • Jail time

You need to consider each creditor's claims.

3. Make a Plan for Paying Off Debts

Now that you've ensured you can stay in your house and meet your legal obligations, you can work on paying down the rest of your debt.

For many people, the most significant part of their debt burden is credit card debt. This type of debt can carry interest rates between 20% and 30%. As a result, much credit card debt comprises late fees and accrued interest in addition to the cash borrowed.

Banks that issue credit cards can reduce your debt and avoid loss if you negotiate with them. In such cases, banks require you to make a lump-sum payment. Agreeing to this reduction may have tax consequences, as any debt written off or forgiven may be deemed able income.

If you don't have the cash to make a lump-sum payment, pick the loan or credit card with the highest interest rate and put as much money as you can toward that debt. Once that debt gets paid off, cancel the card and move on to the loan with the next highest interest rate. You may also shop around for a new card with a lower or special interest rate and transfer the debt. The lower rate will save you money and slow the growth of your debt as you work to pay it off.

You may also consider combining your loans with a debt relief option. This involves taking out another loan and using it to pay off your existing debt. Once consolidated, you pay off the new loan over time. You may also save money with lower interest rates on the new loan.

Another option is to choose your smallest credit card or loan and focus on paying that one off first while maintaining minimum payments on others. Some like this plan because it makes you feel more accomplished during this process as you pay off the smaller debts and move on to the next.

4. Pay Your Deferred Loans

Finally, most student loans allow you to defer payments when you experience difficult financial times. The loan will still accrue interest while in deferral, but the interest rate is usually lower than that of other types of debt. Federal student loan administrators have many repayment options that can work with your financial situation.

Once the rest of your debt is under control and you have a steady income, you can resume payments on your deferred loans.

Should You Consider Bankruptcy?

If you're facing insolvency or overwhelmed with debt, you may consider filing for bankruptcy. Two bankruptcy processes are available for individuals: Chapter 7 and Chapter 13.

Chapter 7 bankruptcy is a liquidation process. Your eligible assets are sold with the help of a trustee to pay your creditors pro rata. Secured creditors receive payment first, followed by unsecured creditors. The court will discharge your remaining debts.

Chapter 13 bankruptcy, also known as reorganization bankruptcy, is a type of bankruptcy in which you, a trustee, and your creditors negotiate a repayment program. You make one payment to the trustee, who distributes the funds. The program lasts three to five years. If you complete the program, the bankruptcy court discharges your remaining debt.

Bankruptcy is often viewed as a last resort. Bankruptcy stays on your credit for seven to 10 years, and it can have a serious impact on your credit score. But your credit score may be lower to start with based on your past due debts. Filing bankruptcy will not discharge:

  • School loans
  • Child support
  • Alimony
  • Recent tax debts
  • Awards or fines owed due to personal injury or criminal offenses

Consider Credit Counseling

If you file for bankruptcy, you must complete an approved credit counseling course and also a second debt management course. Even if you don't file for bankruptcy, consulting an accredited credit counselor is helpful. You will learn money management skills, and they may help you develop a repayment plan and negotiate with your creditors.

Research the counseling agency to avoid scammers. You may check with your bank or credit union for referrals or with the Better Business Bureau.

Know When To Ask for Help

Repaying debt is difficult and draining for many borrowers. But there are options. If you are overwhelmed, facing creditor harassment, and considering bankruptcy, consult a bankruptcy attorney. A bankruptcy attorney can review your situation and provide legal advice.

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