What debt to pay off first?

There are two ways to approach paying off your debt.

Snowball Debt Approach

This approach requires that you pay all the minimums on all your debts except for one (usually the smallest one).  Every month, you pay the absolute highest amount possible until it’s gone.  Once you’ve paid off the first debt, you take whatever you were paying on that debt and put it toward your next target (along with the minimal payment it used to have).

Once you pay off the second debt, you move onto the third debt where you pay the first minimum payment, plus the second and third minimum payments in addition to any extra you can handle.

This method is called the snowball approach because the amount you’re paying into each debt continues to grow (like a snowball) after each new debt is paid off.  For example, if you had six credit card payments all with a minimum payment of $100 a month, plus another $200 a month you could pay towards them ($800 total a month), you’d start the snowball approach by paying $300 toward one debt.  Once that was paid off, you’d pay $400 on the next debt, then $500 when that’s paid off, etc.

Mathematically Speaking

While it sounds like a good approach, not all financial advisers believe that it’s the best way to pay off your debts.  While the snowball approach is good because it keeps you motivated as you keep seeing credit card accounts hit $0 owed, mathematically speaking it makes sense to concentrate on paying off the cards with the higher interest rates first.

When it comes to paying the higher interest rate first, you also have to consider the balance on these cards.  You may have a card with an APR of 29% and a balance of $900, but you also might have a card with an APR of 27% and a balance of $3,000 — obviously, paying the higher interest rate off first would be more costly.

Worst Entries for a Credit Report

When you check your credit report you’ll see numerous entries from your past and present:  personal loans, car loans, student loans, credit cards, etc.  Hopefully, all of your account entries are in good standing — they’ll be described on your credit report as “Current,” “Present,” “Paid as Agreed” or some variation.

Unfortunately, you may have some bad entries on your credit report as well.  Lates are bad, but they’re not nearly as bad as some of these:

Charge-Offs
If you stop paying a bill for more than 6 months (or longer), you may force your creditor to consider your account as being not collectible.  When this occurs, the creditor writes off the account as a loss and updates your credit report noting that your account has been “Written Off” or “Charged off.”  Charge-offs remain on your credit report for a period of 7 years.

Debt Collection Accounts
Once a creditor marks your account as being a charge off, they’ll normally pass you over to a debt collector to try and receive payment from you.  The creditor will also change the status of your account to “currently in collections” or some variation.  In addition, the debt collector may also place their own entry on your credit report stating that you owe $X amount.

Bankruptcy
Filing for bankruptcy allows you to legally stop paying your debts and be free of all liability of paying them, depending on the type of bankruptcy you file.  You credit report will reflect this.  And while the bankruptcy information will be reflected on your credit report for a period of 7-10 years, you should be able to restart building your credit again soon after your debts have discharged.

Tax Liens
When you fail to pay any kind of tax to the government, they have the ability to not only seize your property, but also add a tax lien on your credit report stating that you owe money.  Unpaid tax liens will remain on your credit report for 15 years, with paid tax liens staying put for 10 years.

Lawsuits and Judgments
If a creditor or debt collector has been pursuing you for years and feels that they’ll collect their money no other way, they may attempt to sue you and take you to court.  If they win and a judgment is entered against you (the court determined the debt is valid), it will remain on your credit report for 7 years.  This is regardless if you pay the judgment or not.

Hiring a Debt Management Service

Do you feel like you can’t keep paying all your bills on time?  Are you “over your head,” spending more each month on bills then what you take in?  Well, you might be a good candidate for a debt management service, a program usually available through a credit counselor.

What exactly is debt management?

A debt management program, or debt management service, basically acts as a middle man between you and your creditors, the people you owe money to.  Instead of paying numerous different creditors every month, you would instead send one big payment into the debt management company and they pay your creditors on your behalf.  They do this for a small commission, usually a percentage of your monthly payment.

Debt management is normally only good for unsecured debts, like credit cards.  If you have debts like home mortgages or car loans, debt management may not provide you with much benefit.

What effect does debt management have on my credit?

One of the benefits of debt management programs is that they may be able to reduce some of your unsecured debts’ interest rates and/or balances.  However, this will most likely have a negative effect on your credit report as it will show future creditors that you are a higher risk.  To keep it into perspective though, debt management programs normally have a far less negative impact on your credit when compared to a long history of late and missed payment if you choose not to enter a debt management program.

Profit vs. Non-Profit Debt Management Services

When many private, for-profit debt management services started appearing in large numbers in the late nineties and early 2000s to market to those in debt, many financial professionals advised people to obtain help from nonprofit debt management companies.  The logic behind that is that those offering for-profit services charged larger commission rates than those non-profit companies.

Unfortunately, this is no longer the case.  Many very much for-profit companies now call themselves “non-profit” — nothing more than a marketing term.  There is a huge different than a charitable organization and those that claim to operate as a “non-profit.”  So, before you go shopping around for a debt management company, know that non-profit doesn’t necessarily mean cheaper and better intended.