Advice about paying off debt usually tells you to pay off your high-interest debt first. But what really counts as high-interest debt? Is it a simple matter of looking at the numbers on your various bills? Yes, but there are additional details that are helpful to note.
The simple truth of the matter is this: The higher the interest rate, the harder you want to work to pay down that debt ASAP. But you should also consider the type of debt you’re dealing with.
Is your debt revolving or installment based?
Credit card debt is some of the most expensive debt to pay off because it’s revolving. You don’t just take out one dollar amount as a loan—you have access to a steady stream of credit. And no one’s there to cut off your spending until you hit your credit limit.
It’s rare to see a credit card with an interest rate below 10%; the average right now is about 16%, according to CreditCards.com. Your credit score and the type of card you have are factors in how credit card companies determine your interest rate. People with credit in the mid-600s have an average credit card interest rate of 23.4%, while store cards have an average interest rate of 25.4%, according to Wallethub.
Credit cards usually have the highest interest rates than other debt, and their status as “revolving” can make it harder to predict your payments from month to month. Your minimum payment is not only based on your interest rate, but on how much you’ve spent. And once your interest gets added to your spending, the interest compounds—meaning you get charged interest on your interest. It builds until you stop it from building, by stopping spending and paying your balance in full.
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While you may have a lower credit card balance than the balance on other debts, that high interest rate can sneak up on you fast. Start with your credit card debt if you want to make the biggest impact on your financial health up front.
If you’re looking at loans (mortgage, auto, student, personal, etc.), your debt is likely broken into tidy installments. If so, read on to lear how to prioritize those debts.
Is your interest simple or compounding?
What about other debts, like loans? Again, it depends on the type of loan and how interest accrues.
Interest rates for personal loans can range from about 5-35%. If you have excellent credit (above 720), you’re probably looking at 12% or less. “Good” credit somewhere between 690 and 719? You’re probably getting offers in the 13-15% range, Bankrate says.
Car and student loans often have lower interest rates, with federal student loans offering the lowest rates of all. If you have a few different debts with similar interest rate ranges, take a look at how the interest works.
If you have a loan that charges simple interest, you’ll be able to see your entire payment schedule (it might be listed as an “amortization schedule” in your loan documents), with every installment broken down neatly over the course of your repayment period.
But some loans (like mortgages and student loans) charge compounding interest, meaning that even if you make the same payment each month, interest will keep building up.
So if you want to have the greatest impact on paying down your loans, start with those that have compounding interest over those that charge simple interest.
Totally confused? Go back to the 5% rule
Not sure what kind of debt you have? You can always ask your lender questions about the type of loan you have and how interest accrues.
And if the details have you feeling stuck, go back to the numbers: the interest rates on each of your debts. Anything higher than 5% takes priority. Anything below 5%, you can continue to make minimum payments on and deal with later.
It’s all about the 5% rule of investing, which determines whether you should accelerate you debt payoff or focus on investing. If your debt has an interest rate lower than 5%, your money will grow faster in investments than the money you’d save paying off your debt.
But you’re not worried about investments right now—just debt. If you’re looking at debt with interest of 5% or greater, consider it high interest and focus on tackling it in the order that works for you based on the guidelines above.
