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Common advice on clearing debt often urges prioritizing high-interest obligations. But what exactly is considered high-interest debt? Is it as simple as comparing the interest rates on your different bills? It’s true, but there are more factors worth considering.
Here’s the fundamental truth: The higher the interest rate, the more urgency you should have in paying off that debt as soon as possible. However, it’s also crucial to take into account the specific type of debt involved.
Are you dealing with revolving debt or installment debt?
Credit card debt is among the most costly to eliminate due to its revolving nature. Instead of borrowing a fixed amount, you have continual access to credit. And there’s no one stopping you from spending until you reach your credit limit.
It’s uncommon to find a credit card with an interest rate below 10%; the current average is around 16%, according to CreditCards.com. Your credit score and the type of card you hold play a role in determining your interest rate. Individuals with credit scores in the mid-600s face an average rate of 23.4%, while store cards typically have an average rate of 25.4%, according to Wallethub.
Credit cards often carry the highest interest rates compared to other forms of debt, and their revolving nature makes monthly payments unpredictable. Your minimum payment is determined not just by the interest rate but also by your spending. When interest is added to your balance, it compounds, meaning you end up paying interest on your interest. This continues until you stop it by halting spending and paying off your balance in full.
Even if your credit card balance is lower than your other debts, the high interest rate can quickly add up. To make the greatest immediate impact on your financial health, start by tackling your credit card debt.
When it comes to loans such as mortgages, auto loans, student loans, or personal loans, your debt is typically broken into manageable installments. If that’s the case, read on to learn how to prioritize those types of debts.
Is your interest calculated using simple or compound methods?
What about other types of debt, such as loans? Once again, it depends on the nature of the loan and how the interest is applied.
Personal loan interest rates can vary widely, ranging from 5% to 35%. If you have excellent credit (above 720), you can expect rates around 12% or lower. Those with ‘good’ credit scores between 690 and 719 typically receive offers in the 13-15% range, according to Bankrate.
Car loans and student loans tend to offer lower interest rates, with federal student loans providing the most favorable rates of all. If you have multiple debts with similar interest rates, consider how the interest is calculated.
For loans that use simple interest, you’ll be able to see a clear repayment schedule (often referred to as an “amortization schedule” in your loan documents), outlining each payment in a straightforward manner over the course of your loan term.
Certain loans, such as mortgages and student loans, incur compound interest. This means that even if you make consistent monthly payments, the interest continues to accumulate.
To have the most significant impact on reducing your debt, prioritize loans with compound interest over those with simple interest.
Completely lost? Take another look at the 5% rule to gain clarity.
Unsure of the nature of your debt? You can always reach out to your lender to inquire about the loan type and how interest is applied.
If you're feeling overwhelmed by the details, focus on the interest rates for each loan. Any debt with an interest rate above 5% should be your priority. For loans with rates below 5%, just keep making minimum payments for now.
The 5% rule of investing helps you decide whether to prioritize paying off debt or investing. If your debt’s interest rate is below 5%, your money will grow more quickly in investments than in saving on debt interest.
But if your focus is debt rather than investing, and you have debt with an interest rate of 5% or higher, treat it as high-interest and prioritize paying it off based on the approach outlined above.
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