Is There A Right Order In Which To Pay Off Your Debt?

If one of your goals this year is getting on top of your debt, then first of all, congratulations. Financial education is a sprawling endeavour that can take a lifetime to master, but arming yourself with the right information is the first step in relieving the stress associated with being in debt.

There are many reasons people get into debt. Business failure, unexpected illness, and loss of employment are just a handful. Other psychological reasons like financial trauma and lifestyle creep can also play a part in creating debt. 

Whatever your reason or however much you owe, here are some ways to figure out where to start.

With all those numbers flying around in your head, it can be hard to actually conceptualise how much you owe.

First things first: make a list of every debt you have. 

This includes (but isn't limited to): mortgage repayments, HECS loans, credit cards, any unpaid bills, and fines. Once you add each one up, you can see your overall debt amount. 

While this may be confronting, it’s the first step in getting on top of your money, rather than letting it control you.

Once you have the total number, the next step is to work out which debts are your priority and try to pay them off first. 

Do you have a credit card bill quickly approaching? What about a parking fine that will cost you your licence if you don’t pay up? By paying off your urgent debt first, you can then focus your energy on chipping away at other debts. 

Some examples of priority debt include mortgage payments, bills, car repayments, and council rate and body corporate fees.

While you’re prioritising, it’s also important to check the interest rate on each debt. Every loan granted to you has a different interest rate set by the lender. The interest rate determines how much it will cost to borrow the money in the long run. 

For example, credit cards generally carry a higher interest rate than mortgage loans. After the most urgent debt, a good rule of thumb is to pay off high-interest rate debt next. 

In Australia, student loans such as the Higher Education Contribution Scheme (HECS) have no interest applied, meaning you don’t have to worry about the debt earning interest (and increasing in cost) as you pay it off.

While money certainly shouldn’t carry moral weight, some experts categorise debt into two segments.

'Good debt' is considered to be debt that can ultimately increase your net worth or generate value for your future, e.g. a higher education degree or property. 'Bad debt' is debt that either has high interest rates (e.g. a credit card) or is a depreciating asset (meaning that it devalues over time), e.g. a car loan. 

While you should keep up with the minimum payments on all your debt repayments, if you're strapped for cash, it's generally considered more important to prioritise 'secured' debt, which is, as it sounds, secured by an asset. If you don't pay it, that gives the lender the right to seize the asset e.g. your property, through repossession or foreclosure if you don’t pay on time.

That doesn't mean that you're off scott free for unsecured debt, which isn't attached to anything tangible. Not paying any kind of debt (including things like your phone bill) can have an impact on your credit score, which can impact your ability to borrow money in the future.

We’re not quite done with the financial jargon just yet, but understanding it can be a big help in chipping away at what you owe.

There are another two methods traditionally used to pay off debt in a certain order. These strategies are most useful when you have consumer debt (things like credit cards and car loans) rather than mortgage payments. 

The avalanche method is when you make minimum payments on all of your outstanding loans. With any money left over, you then target the debt with the highest interest rate. This tends to save the most in interest payments.

The snowball method, on the other hand, involves focusing on smaller debts to get them out of the way before tackling larger loans. To do this, you'd make a list of all of the debt you owe, from smallest to largest, and focus your energy on paying off the first $1,000 debt before moving onto the $2,000 debt, and so on. The positive of this method is the psychology behind it. When we can see actual progress by paying off debt and seeing fewer bills, it motivates us to keep going. But since the snowball method doesn't take interest rates into consideration, you can end up paying more by the time you're done. 

Debt is very personal, and often associated with feelings of guilt and shame. Ultimately, there's no "right" way to pay off debt, as you have to find a repayment method and order that works for your circumstances and financial behaviour — all you have to do is get started.

If your debt is impacting your daily life and mental health, professional help and financial counselling are available. Australia has many free debt help hotlines to give you extra support with financial stress.