Different Kinds of Debt
Debt is such a versatile financial tool. You have probably heard of the difference between good debt and bad debt. Good debt puts money in your pocket, like financing a rental home that generates a little bit of income. Bad debt is for purchases of consumer goods that depreciate and do not generate any income. I am going to take things a bit further when it comes to bad debts. If you already have credit cards and loans, there are priorities for paying those off.
First, let us distinguish between revolving debts and amortized debts. Revolving debts are your credit cards. You charge on them, pay them off, sometimes carry a balance, and sometimes struggle to pay them off. Credit cards are often maligned as the worst kind of debt because of the high interest rates they charge. This is done trying to convince you to consolidate your debts into a loan with lower interest and fixed payments.
The reality is that credit card debt is better than installment debts. Credit cards have higher interest. However, it is simple interest on your average daily balance, which you only pay if you carry a balance. Credit card interest is problematic if you are only making the minimum payment. However, if you pay off big chunks on your credit cards, the interest is not so troublesome.
Despite how benign installment loans are made to be with their low interest rates, they are the worst. They lull you into thinking that you are getting a good deal. However, keep in mind that when loans are amortized, they often charge you the interest up front. You don't pay off significant amounts of the principal until you are halfway done with the loan. Installment loans have a much higher volume of interest predetermined from the start.
If you are struggling to make payments and have a combination of credit cards and loans, your best bet is to pay off your credit cards first. The reason for this is that as you pay down your credit cards, the minimum payment gets smaller and smaller. This frees up cash flow so that things are not so tight. In addition, by paying down your credit cards, you still have credit available to spend in an emergency. Obviously, you want to be very deliberate about what constitutes an emergency. The goal is to pay down debt rather than be perpetually in it.
Installment loans are not worth paying extra if you have credit card debt. The reason is that it does not matter how much of a loan you pay off, your monthly payment will not decrease until the loan is paid off in full. In addition, every extra dollar you put into an installment loan is money you won't ever see again. This is unlike a credit card that can still be used as you are paying it down.
Assuming you paid of your credit cards, it is now a good time to make extra payments on your loans. If you have an emergency, you can use your credit cards. At that point, shift your focus back to paying those off again.
Even among credit cards, there are levels of utility. General credit cards are of higher priority than store credit cards. Your general credit card can be used to buy or pay for all manner of goods and services. Store cards, on the other hand, are limited in what you can buy with them. You want to free up the most flexible spending cards first before paying down the less flexible credit cards. For example, gas cards and auto repair credit cards limit you to only buying certain products. You couldn't pay your dentist with a gas card (hopefully).
There are also other considerations to keep in mind when paying off debt. For example, zero percent interest cards can buy you a little bit of time to pay off other things. There are also lines of credit that can be extremely useful for paying off debt in lump sums. You can find out more about cash flow banking to learn how lines of credit can help you pay off debt faster than installment loans.
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