Which Should You Pay Off First, Credit Cards or Loans?

If you have multiple debts the challenge of paying them all off at the same time can seem overwhelming. Prioritizing your debts is an important tool that you can use to reduce your interest payments and get out of debt faster. To do this you will have to look at each of your debts, assess their interest rates and impact on your credit, and select a strategy that will allow you to remain current on all your payments while focusing on the debts you’ve decided to prioritize.

There are several strategies that can help you reduce your debt by targeting your highest priority debts first. In most cases, you will want to pay credit card debt first, as it usually has higher interest rates and a more immediate impact on your credit than installment loans. 

How to Prioritize Debt Payments

There are several points that you will need to consider when allocating your available funds to pay your different debts.

Don’t neglect any debt, even if it has a low priority. Always make at least the minimum payment on each debt every month. If you don’t make the minimum payment you may face penalties and even delinquency, which can harm your credit. 

If you have money left over after making the minimum payments on all your debts, you need to decide where to apply it. Assess two factors.

  • What is the interest rate on each debt?
  • How does each debt affect your credit?

These factors will determine what you should pay in order to reduce the total cost of your debt and how much that debt will impact your credit over the long haul.

Your debts affect your credit score in two ways:

  • Payment history is the single most important factor in most credit scoring systems. As long as you are keeping up to date with minimum payments on each loan your credit history will not be affected. Missed or late payments can affect your credit. 
  • Credit utilization is the percentage of your available credit that you are using. It is a part of most credit scoring systems. If your credit card balances are greater than 30% of your credit limit your credit utilization may have a negative impact on your credit. The higher your credit utilization goes the greater this impact will be. 

In most cases, you will want to prioritize the debts with the highest interest rates and those that have the greatest impact on your credit. Paying off high-interest debt will save you money on interest payments and paying off debts that are hurting your credit can make it easier to get new credit on better terms. These will often be the same debts, and credit card debt will usually be your first target. 

Understanding the Two Types of Debt

There are two basic types of credit: revolving and installment. Understanding the differences will help you prioritize your debts.

Revolving credit allows you to borrow repeatedly as long as you make regular minimum payments and do not exceed a set credit limit. Credit cards are the most common form of revolving credit. 

Here are some of the key factors to consider when prioritizing credit card debt and other revolving debts: 

  • High interest. Credit card debt typically carries higher interest rates than installment loans
  • Credit utilization. If your credit card balance is over 30% of your credit limit your credit utilization ratio may be harming your credit. If your balance is close to your limit the impact on your credit will be even greater.
  • Multiple interest rates. Many credit cards have one interest rate for purchases and higher interest rates for other transactions, particularly cash advances. If you make late payments, you may be hit with penalty APRs. 
  • Rapid accumulation. Credit cards allow you to keep your account in good standing by making only a small minimum payment. This is a tempting but dangerous habit that can quickly lead to a spiral of rapidly accumulating high-interest debt. 

Installment credit involves borrowing a fixed amount and paying it back in set installments. Mortgages, car loans, personal loans, and student loans are all forms of installment credit. 

These are some key features to consider when assessing the priority of installment loans: 

  • Fixed monthly payment. Installment loans have a set monthly payment. As long as you make the payments on time you will be current on your loan and you will build a good payment history. You may not gain many advantages from paying the loan ahead of schedule.
  • Prepayment penalties. Some installment loans may have a prepayment penalty. In these cases, it may cost you money to pay your loan ahead of schedule.
  • Positive impact on credit. Keeping installment loans open may help your credit, as long as you keep your payments current. Lenders like to see a mix of revolving and installment credit and paying off an installment loan can give you a less advantageous credit mix, especially if it’s the only installment loan you have.
  • Low interest rates. Installment loans typically have lower interest rates than credit cards.

We can see from these features that credit card debt usually has higher interest rates and a greater impact on your credit than installment debt. Running a high balance on your credit cards will hurt your credit utilization and leave you with high-interest costs. If you keep up with your payments, installment credit will not harm your credit and may even help it.

In most cases, paying off your credit card debt will be your first payment priority.

How to Prioritize Credit Card Debt

If you have only one credit card, it’s easy to prioritize. Make the required payments on your other loans and devote all the money that you can spare to reducing that credit card balance until you are paying it in full every month. 

If you have more than one card there are several approaches you can take to prioritize your debt payments: 

  • The debt avalanche method focuses on the balance with the highest interest rate. You make the minimum payment on all your other accounts and use every available dollar to pay off the balance that’s carrying the highest interest rate. Eliminating that debt will save you money that you can use to help you pay the debt with the next-highest balance. 
  • The debt snowball method focuses on paying the smallest balance first. You make minimum payments on every other debt and focus on paying off that smallest debt. The sense of accomplishment you get from paying it will help motivate you to take on the next smallest balance. 
  • A balance transfer credit card can be a useful way to pay off debt. Many balance transfer cards come with a zero-interest promotional period. If you transfer your other balances onto that card and pay the balance before the promotional period expires you can focus your payments on reducing the principal rather than paying interest. Be sure that the balances you intend to transfer are below the credit limit on your balance transfer card. If you can’t pay the card off within the promotional period, you may be faced with a high interest rate on the remaining balance. You may need good or excellent credit to get a balance transfer credit card with good enough terms to make this strategy worthwhile. 
  • Debt consolidation with a personal loan can replace high-interest credit card balances with an installment loan that carries a lower interest rate. You apply for a personal loan, use it to pay off your credit card balances, then pay off the loan. You may need good or excellent credit to be eligible for a personal loan with a low interest rate. 

Whichever method you choose to pay off your credit cards, it is very important to stop making new charges on your cards while you are trying to reduce your credit card debts. 

How to Prioritize Loan Payments

The debt avalanche and debt snowball methods can also be used to prioritize installment loans. There are several features you’ll want to look into before prioritizing installment loans. 

  • Check your loans for prepayment penalties. If a loan has a penalty for early payment you probably shouldn’t accelerate payment even if the loan has a higher interest rate than your other loans. 
  • Consider the fees. Before you compare the APRs, or Annual Percentage Rates, of installment loans, check to see if the loan fees were paid upfront or distributed among your payments. The APR on an installment loan includes the fees, and if you’ve already paid the fees you won’t want to include them in your comparison. For loans with upfront fees you will compare the interest rate that you are paying on your balance, not the APR.
  • Consider refinancing. If your credit has improved since you took out longer-term loans like student loans, car loans, or private student loans, you may be eligible for a substantially better interest rate. Be careful about refinancing Federal student loans, though. You may lose access to valuable repayment plans and other options. 

Once you’ve decided which loan you want to pay off first, make the minimum required payment on all your loans, and devote any extra money to paying off the loan you’ve prioritized. 

Conclusion

If you’re committed to paying off your debts, prioritizing is an important tool that can save money, keep you motivated, and help protect your credit. In most cases, you’ll want to prioritize your credit cards over installment debt. Choose the payment strategy that suits your needs and commit to it.

Once you’re in control of your credit card debts, apply the same strategy to your installment loans.

Remember that you should always make the minimum monthly payment on every debt, even the ones with the lowest priority. The last thing you want while you’re paying down debt is to have late payments or defaults on your record.

Debt can seem overwhelming, but it doesn’t need to be. Organizing your debts, setting priorities, and adopting an effective debt payment strategy can set you on the road to freedom from debt.

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