What Order Should I Pay Off My Debt?

Stacy writes in with the following questions regarding getting out of debt:

Q: If you have a canceled credit card and its balance is the lowest should you work on paying that one off first or one that isn’t canceled? Also, would you work on paying over the credit limit cards or paying off payday loans first?  We have ideas but just aren’t sure where to start and attempt to tackle the debt.

A: Stacy, there are about as many ways of paying off debt as their blogs dedicated to the subject!  First of all, I commend you for taking control of your financial situation and eliminating the temptation to go even deeper into debt.

The usual advice is to wait until your card is paid off to close it, because it can be detrimental to your FICO score to reduce the amount of credit available. Having said that, I’ve violated this advice myself and closed an account before paying if off because of the way the credit card company treated me.

From your question, it sounds like you have a variety of debts including a canceled credit card, an over-the-limit credit card or two, and some payday loans. The standard advice is to pay off the debts in the order of the interest rate – paying off those with the highest rates first. In my own experience, I have found that method of snowballing debt to be tougher to work through because of the lack of emotional reward returned.

However, if you go this route, move your balances after considering the 18 month promotional balance transfer offer from Discover® More Card.

I recently linked to an article over at Man vs. Debt about the Debt Tsunami method of paying off debt.  According to this debt snowball style you line up the debts giving priority to the one that is most emotionally charged. or gives you the biggest emotional boost when paid off. In your example, that might be the payday loans, or a personal loan that you’d like to clear from your list of debts. For me, it was my car loan, because since marrying my wife eleven years ago I’ve never known freedom from a car payment.

The other thing to consider is the fees associated with the over limit credit cards. Perhaps it makes sense to prioritize those first until the point that they are all safely under the credit limit and current. Then you can regroup and reorder your debts in the priority that works best for your situation.

Finally, there is no easy way out of debt. For me, the climb out of debt has taken more dedication, more perseverance, and more sacrifice than anything in my life up to this point. However, the rewards at the end are just as sweet. I suspect because you took the time ask for help with lining up your debts that you also have a gameplan for paying them off, and I have little doubt that you can do it. Let us hear from you again when you are debt free!

Comments

  1. Just read an article about credit card on Yahoo- totally counter-intuitive. It says you shouldn’t cancel the credit card once you pay off the card because then it will reduce your credit limit and somehow count toward your FICO score. Care to elaborate on this?

  2. Paying off debts is an emotional roller coaster. Like the Debt Tsunami suggests, pay off the ones with the highest emotional baggage first. If they all hold the same level of emotion then start with the highest interest/fees. Don’t forget to build a small emergency fund as well.
    I would also wrap the Credit Cards in a piece of paper on which is written, “Last month I gave Visa (Mastercard/AMX) $xxx of my hard earned money!” The $xxx is the amount of interest you paid them. This will help you fight that urge to splurge. Yes, I know it’s on sale. Yes, I know it’s absolutely darling. No, I cannot afford it.

  3. @Vivian: One of the primary components of your FICO score is your credit utilization ratio – the amount of debt you have versus the total amount of your credit limits. Imagine a $3k balance on a $10k credit card – your credit utilization would be 30%, near the high end of what’s considered “good” in FICO score modeling.

    If you pay off that credit card, but still have other debts, then the $10k limit is still being counted as part of our available credit lines and helping to reduce your credit utilization ratio. If you close that account, and the $10k is no longer counted, it could drastically increase utilization and hurt your score.

    Bottom line, if you aren’t planning to borrow more money, who cares? Pay off the card, close the account and enjoy life without the hassles of a credit card. However, if you plan a major purchase, such as a home, in the next few months, it may be wise to leave things opened to help your score until the financing for that purchase is behind you.

    Thanks for your question!

  4. Nope, you can close it, but you’ll still have to pay it off.

    By the way, it’s true about closing a card before you go for a loan–we did that with my husband’s card and another card, and ended up paying for it with a higher interest rate when we refi’ed our house. Bad move. But it might have six of one, half dozen of another: the high credit ratio may also have been a bad thing. We simply had too much in proportion to our income at that time.

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