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Prioritizing which loan to pay off first

Trying to pay down personal debt is not an easy task. It takes determination and patience to be successful in paying off loans and other outstanding debt. If you are like most people, you have really good intentions but may not even know how to begin the process.

You should be aware that not all debt is created equal. Secured loans, which are guaranteed with some type of collateral (such as a home or car), deserve special consideration when you are attempting to decrease your total debt. If you default on a secured loan, you run the risk of losing your home to foreclosure or having your car repossessed.

No one is suggesting that you ignore your debts. Financial experts agree that you should pay at least the minimum amount on all of your debts in a timely manner, each and every month. But the harsh reality of today's economy is that not everyone is able to do this and sometimes there just isn't enough money coming in every month to pay every bill that's due.

Depending on your personal situation, there are three debts which you might consider not paying off if you are currently strapped for cash.

  • Unsecured debts. These are debts which are not backed by an asset (collateral). Examples of unsecured debt are credit card bills and any outstanding medical or hospital bills. The reason for this is that if you don't make payments on a secured debt such as a car loan, the creditor may repossess your car. With unsecured debt, there is no asset to lose.
  • An “upside-down” mortgage. The past few years have seen millions of American homeowners lose the equity in their homes. In fact, many are now in the position of owing more to their mortgage lenders than their homes are actually worth. Many financial planners recommend that people who are seriously underwater with their mortgages need to consider walking away from their properties. While this is an extreme and unpleasant scenario to imagine, continuing to pour cash into a mortgage for a home which may not regain its previous value for another ten or twenty years may not be the smartest financial decision to make in terms of your overall financial future.
  • Old Debts. This may not apply to everyone but it's good information to have. Credit reporting companies are required by Federal law to remove debts from your credit report after seven years. If you have an old debt that has been hanging around for 5 or 6 years, it is probably not worth paying off. Especially if you are trying to pay your mortgage (or rent), your utilities, your car loan, and put food on the table. Also, if you haven't paid on the debt in years, making a payment will start the process all over again and it will remain on your credit report for another seven years.

Prioritizing Your Debt

Once you determine all the outstanding debt you have (and perhaps eliminate the ones listed above if they apply), you can decide where to begin with your debt reduction plan. Many financial experts suggest paying off the smallest account first (making larger payments) while making the minimum amount on the larger debts. When the smallest outstanding debt is fully paid off, you then apply the money you were spending towards it and tackle the next smallest debt on your list. You keep doing this until all of your debt is paid off.

Here are the basic steps to follow:

  • List all of your debts, starting with the one that has the smallest balance. It doesn't matter what the interest rate is, just the total amount that you owe. If you have two accounts with similar balances, pay off the one with the higher interest rate first.
  • Agree to pay the minimum amount on every debt, every month.
  • Calculate how much extra you can afford to pay on the smallest debt.
  • Pay the minimum plus the extra on the smallest debt until it is completely paid off.
  • Once a debt is fully paid, pay the minimum amount plus as much extra that you can afford towards the next smallest debt.
  • Repeat this process until all of your debts are paid in full.

A Final Thought

These suggestions for paying off your personal debt will only work if you have enough income each month to pay the minimum amounts due and also to provide the extra money needed to apply towards reducing your outstanding debt. If you are unable to pay the minimum on one loan, there is really no point in paying extra on another bill. It probably makes more sense to make the minimum payments on all of your debt and try to remain current.

In the meantime, consider ways to cut your spending and bring in more income. Perhaps you can look for a second job (even if it's only temporary). Look around your home for items to sell. Yard sales and selling over the internet provide quick and easy ways to generate cash.

The positive news is that you are beginning the process to get out from under overwhelming debt. It may take some time but the rewards of being debt-free and financially independent are priceless. Be proud of yourself!