When it comes to paying off debt, knowing which debts to prioritise and pay off first can save you the extra money in accumulating interest and get you closer to eliminating another of those monthly instalment burdens.
There are various ways to get rid of debt, and in this blog, we look at which debts you should pay off first.
Should you pay the secured debt or unsecured debt first?
A good rule of thumb is to pay off debts according to the interest rate, starting with the loan with the highest interest rate, because a high-interest loan will add more interest to your balance as time goes by.
Types of unsecured debt, usually consumer debts, personal loan or credit card debt, have a higher interest rate than secured debt. Secured debt examples include your monthly home mortgage or vehicle instalment.
Considering unsecured debt versus secured debt, paying off unsecured debt first and getting rid of accumulated high interest makes sense. You save that extra interest that you would otherwise pay towards your loan.
Why pay off the high-interest debt first?
The reason for the increased interest in unsecured debt is simple. Unsecured debt does not require collateral that can be sold to repay part of the loan when the borrower defaults on the repayments. Thus it poses more risk of non-repayment to creditors.
By comparison, secured debt uses your home or vehicle as collateral; it is safer for the bank or lender; therefore, secured loans often come with lower interest rates than unsecured debt.
There is another huge benefit to paying off high-interest unsecured debt first, aside from saving on added interest. As you pay off these debts, you eliminate them one by one and focus only on paying off low-interest debts, e.g. your home loan and car finance.
This is known as the snowball or avalanche method, where you focus on paying off several smaller debts by interest rate. Your credit utilisation ratio becomes much lower, too, which is good news for your credit score.
Specifically, your credit utilization ratio calculates how much you still owe to creditors (on a credit card, for example) compared to your total credit limit (on the same credit card). The lower this percentage, the better.
By paying off debts, you owe less to banks and lending institutions, and your ratio improves. Generally, creditors view 25-30% as a good credit utilisation ratio.
The goal of paying unsecured debt first is to work faster towards paying off debt until you are left only with secured debt in your budget. At this point, it is easier to put a plan into action to become debt-free one day.
Need help in paying off unsecured debt?
Despite your best efforts to reduce unsecured debt, you may struggle to manage multiple credit lines, high interest, increased outstanding balances on credit cards, and a dangerously high credit utilisation rate.
Irregular and missed payments are also familiar with mounting unsecured debt. For creditors, this is a sign that you are heading into major financial trouble and you need help.
Debt counsellors can take an objective look at high-interest unsecured debt to reduce the number of monthly instalments and devise an affordable repayment plan, thus minimising the risk of non-payment to financial institutions.
Bundling all your unsecured debt together in one monthly instalment and renegotiating interest rates simplifies debt management to the point where you can confidently resume payment and eliminate bad high-interest debt once and for all.
Our professional ezDebt advisers can help you stay on track with debt repayments through a quick and affordable debt counselling. All our debt counsellors are registered with the National Credit Regulator (NCR). Get in touch at www.ezdebt.co.za.