If you are feeling overwhelmed by debt, it can be difficult to anticipate a future where you are debt-free. Studies show that high levels of debt can have a severe negative impact on your mental health and can leave you feeling angry, sad, and anxious.
However, if your debt has snowballed to the point where it feels unmanageable, don’t despair. Knowing how to prioritize your debts and pay it off in the most efficient way possible will soon get you back on track. This article will help you understand how debt priority works, lay the foundations for a basic repayment plan, and get you on your way to becoming debt-free.
The Basics of Prioritizing Your Debts
Debts can be organized into two broad categories: secured vs. unsecured debts and high priority vs. low priority debts.
1. Secured vs. unsecured debts
Secured debts are liabilities guaranteed by collateral. The bank or lender will loan you money subject to it obtaining a right over an asset or other surety.
The best example of a secured debt is a mortgage. The bank lends you money to purchase a property. To protect the bank’s position (i.e., ensure it will be repaid), the bank secures a legal charge over the property. If you fall into arrears with your mortgage, the bank can repossess your home.
Other examples of secured debts are:
- Hire purchase agreements
- Loans secured by guarantee (here, the security is the right to pursue a named third party for repayment of the outstanding debt)
Unsecured debts are liabilities with no security attached. Examples of unsecured debts are:
- Personal loans
- Credit cards
- Student loans
- Medical bills
- Auto loans
If you default on unsecured loans, it is unlikely the lender can repossess your assets. However, because the lender’s position is not protected by security, these loans tend to be more expensive, with higher interest rates. It is therefore easy for unsecured debt to spiral out of control.
2. High priority vs. low priority debts
The general rule is, the more serious the consequences of not maintaining payments, the higher priority the debt should be.
Secured debts are usually high priority, and unsecured debts, low priority, because the consequences of defaulting on secured loans are harsher than defaulting on unsecured debts. For example, if you default on secured loans, the lender can repossess its security — for example, your house, car, or laundry machine.
However, this is not a hard and fast rule. Here are examples of unsecured debts which should always be considered high priority due to the consequences of non-payment:
- Court orders and fines
- Child maintenance
If you do not pay these debts when due, you could face further penalties, or even be imprisoned.
Rent is also a high priority unsecured liability because the consequence of falling into rent arrears is the same as falling behind on your mortgage – repossession of your home.
Another type of unsecured debt which may be high priority are utility bills. If you do not pay your water or electricity bill, the power provider will switch off your power. However, power companies tend to be more lenient.
If you are struggling with debt, consider contacting your power provider (before falling into payment arrears if possible) to discuss the possibility of temporarily reducing your payments. If your power provider agrees to enter into a repayment agreement with you, you can consider utility bills a lower priority debt.
3. Debt emergencies
While this article does not focus on what to do if you are facing legal action, debt emergencies are extremely high priority and should be addressed before any other debts. Examples include:
- Court action to recover a debt
- Repossession action
- Bankruptcy proceedings
- Bailiff action
If you are facing a debt emergency, seek debt counseling immediately for advice on what to do.
Most lenders want to avoid taking legal action against you. It’s never too late to initiate contact with your lender and try to negotiate a payment plan. You could even offer a reduced lump sum payment (if affordable) and pay off the loan in one chunk. The lender may accept this to get the loan off its books immediately.
If you are facing repossession action, consider the possibility of refinancing or selling the property yourself.
Prioritizing Your Debts in Practice
Once you understand the different types of debt, it is easier to prioritize efficiently. Every month, the first thing you should do is pay your high priority debts, then you can worry about your low priority debts.
Even if your debts heavily outweigh your income, it is possible to get yourself on track to becoming debt-free by coming up with a monthly payment plan.
First, work out the amount you can dedicate towards repaying your low priority debts each month: Take your monthly income and subtract your necessities such as food, clothing, gas for the car, and so on. Then subtract your high priority debt payments such as your mortgage and utility bills.
The remainder will be spent reducing your low priority debts.
Prioritizing Your Low Priority Debts: The Debt Avalanche Method
Create a list of all the low priority debts you owe including:
- The amount outstanding
- The interest rate (APR)
- The minimum monthly payment
The most efficient way of repaying your low priority debts tends to be by using the debt avalanche method. With the debt avalanche method, you aim to pay off the debt with the highest rate of interest first. Over time, your debts accrue less interest, and you can pay them off faster.
First, ensure you are paying the minimum payments on ALL your debts to avoid the lender taking any action against you. Then, use whatever remainder you have in your monthly budget to reduce the amount owing on the debt with the highest interest.
For example, you have the following low priority debts:
- Credit card – $2,000 outstanding with 17.5% APR
- Medical bill – $5,000 outstanding but the hospital has allowed a break from interest
- Auto loan – $500 outstanding with 3% APR
Although you owe more on the medical bill, the credit card has a higher rate of interest. Therefore, prioritize the credit card debt above your other low priority debts.
Prioritizing Your Low Priority Debts: The Snowball Method
The debt avalanche method is not for everybody. Some people have many little debts and many minimum payments to make. Each month you might receive a dozen statements, and it makes it hard to keep on top of what you owe to whom.
With the snowball method, you pay your debts starting with the smallest amount outstanding and work your way to the biggest amount.
Because the snowball method gives you small but regular victories, it can feel more like you’re making a real dent in your debts. Regaining control over your finances is about perseverance, and the snowball method can encourage that.
For example, in regard to the above theoretical debts, you owe the least on the auto loan, so you repay that debt first, regardless of interest rates. However, be aware that with the snowball method, you may end up paying more overall.
To sum it it all up… (the TL;DR)
The journey to paying off your debts can be long and arduous. However, just a little perseverance and an understanding of the fundamentals of prioritizing your debts, and you will soon be on your way to becoming debt-free. Here are some final tips to get you started:
- Remember to pay your highest priority debts, such as your mortgage, first each month.
- Start conversations with your lenders about the possibility of repayment plans, reductions in interest, or even interest freezes. Many people feel ashamed of their debts and want to hide their troubles. However, the more open you are with your lender, the more likely they will be to help you to make your debts more manageable.
- Furthermore, working out which lenders are prepared to cooperate with you can help you prioritize your debts. For example, if your hospital allows a payment break on your medical bills, that debt can be prioritized below, say, your federal student loan payments.
- Work out which method of prioritizing your low priority debts is best for you: debt avalanche or snowball method.
- And finally, persevere, persevere, persevere. It takes dedication to ultimately become debt-free.