How to Prioritize Debt

Step 1 of My 5-Step Roadmap Towards Building a Solid Wealth Foundation

Re-Framing Your Debt Mindset

When you ask the typical person about debt, most react negatively. “All debt is bad,” a lot of the so-called “experts” will say, but what if I told you that most wealthy people use debt as a tool to grow their wealth? What if you looked at it through the lens of: debt is a tool and there is a spectrum of very bad to very good debt? When you change your frame of mind about debt, learning how to prioritize your debt will become simple.

Before we get into the specific numbers of what makes good debt and what makes bad debt, let’s put some common sense to work. Interest rates aside, let’s talk about why we take on debt.

Are you becoming a homeowner, adding a huge asset to your net worth? That sounds like a good investment! Kudos to you. Are you getting a college degree so you can increase your opportunity? Congratulations! That also sounds like a great investment for your future. Did you unknowingly or knowingly misuse your credit card and buy a bunch of stuff that you don’t necessarily need? Maybe that’s not such a great investment.

It’s important to keep in mind what you’re getting from that debt. Good debt usually improves our situation for the long term and you shouldn’t be ashamed of it. If anything, you should be proud of it…and treat it accordingly. Bad debt usually puts us at a disadvantage. For example, overbuying furniture or clothes don’t don’t move the needle on the asset side of your net worth.

Now let’s get down to numbers and establish this debt spectrum. The best indicator for determining the quality of debt is interest rates. It is quite simply, the cost of borrowing. With the assumption of debt being fixed, in general, the lower the interest rate, the better. The higher the interest rate, the worse quality it gets.

At what interest rate percentage does debt start to get troublesome? This might vary from professional to professional, but I have found that an interest rate of 7% or below is considered to be “good.” In other words, around 7% interest rates start to get expensive and the cost of borrowing may not be worth it.

At the time of this blog post being written, the Fed Funds Rate is 4.25-4.5%. Keep in mind, the interest rate a bank may charge you is likely to be a couple points above this, depending on your credit score, past income, etc. This is a sharp increase from the past decade where interest rate hovered between 0-2.5%, thanks to the Financial Crisis of ’09.

Speaking of history, the historical interest rate data in our country tells the story of where the negativity around debt comes from. Did you know that in 1981 the Fed Funds Rate got up to 19.99%!? That was the peak from the decade before where rates hovered around 9-10% and never got below 4%. No wonder the Boomer and Gen X generations are terrified of debt! It was all high, all the time.

Today paints a different story, though. Humans have a short memory, tend to hyper-focus on the negative and most have a healthy aversion to change. So while the days of 0% loans are in our rear view mirrors (for now), interest rates are historically still pretty low. And now that they are rising, people are just now starting to realize how good they could have had it–and the idea of rushing to pay off those low interest loans are finally seen as preposterous, right? Right?!

Just this morning we met with a prospective couple who have a 3.5% interest on their mortgage, and they’re overpaying by $500 each month. I tried not yell out “stop doing that!” before we even create their financial plan, but it really is a simple notion: if you have a low interest, you’re able to increase your net worth at a cheap price. Instead of that extra savings going towards a low-interest loan, in most cases, it can be put to better, more effective use through investing or by building up your Emergency Funds, depending on your unique situation.

How to Prioritize Your Debt

Now that we have confronted our stereotypes about debt and know how to determine what kind of debt we have, let’s focus on how to prioritize your debt and efficiently & effectively pay it off (or perhaps not focus on paying it off!)

Before we address the next layers of foundation for wealth (Steps 2-5 coming soon!), we have to throw most of our efforts at either paying down the high interest debt and/or lowering the interest rate. Why? Because that high interest is keeping you from growing your net worth and costing you a LOT of money.

That means that debt with an interest rate over 7% needs to be prioritized to be paid off. This is most often your high-interest credit cards that typically over around 20-25%. Although, a lot of younger people or immigrants get dealt a high interest rate loan because of the lack of their credit and income history.

My husband, for example, needed to buy a car, but had to accept a 18% interest rate in order to purchase after just a year in the states. Once we were engaged, I added myself to the loan, and we got a credit union to take over the loan. We were able to then get a 1.99% interest rate. Our babysitter is in a similar situation. She had to accept a 12% interest rate for her auto loan, but she is now seeking a refinance now that she has some income history.

Whatever the reason you have entered into high-interest debt (and most times it’s out of necessity), I urge you to move past any shame that you might have and channel that energy towards savvy wealth-mindset decisions that can get you out of it as fast as possible.

First, here are a few strategies you can implement to improve your situation outside of just paying it down:

1. Look into a transfer balance, which is basically moving your debt to a new credit card that offers 0% for about a year for a small % fee (typically 3-5% of the amount you transfer.) This buys you some time and interest relief. Do the math by dividing the new total by the amount of months you have until the relief period is up. That number is your new monthly payment. Just make sure you pay it off before the interest starts back again!
2. Call your lender and negotiate a lower rate. This is an common, yet often overlooked strategy for all types of high interest loans/debt. Sometimes all it takes is a call, y’all!
3. Consolidate your loans into one loan with a lower average interest rate. Check with companies like Payoff.com or Upstart.com to see if you qualify. There are a lot of online companies these days…shop around for the best interest rate. NerdWallet has a good roundup here.
4. Got a high interest auto loan? Check with your local credit union! Credit Unions can refinance your loan and are known to offer lower, more forgiving interest rates than your regular banks. I personally have mine at a credit union!
5. Have a mortgage with an interest rate over 6% and have lived in the home for more than a few years? Look into a refinance. The lender can roll the costs of the refi into the loan so you may not even need to cough up the up-front fees. A hidden benefit if you’ve owned for a while and your home value has appreciated is that you may be able to take off your Private Mortgage Insurance (PMI) if your loan-to-value ratio has increased. Contact a local mortgage loan officer today to get some quotes and discuss your options.

Once you have exhausted all of your efforts to reduce your interest rate, consolidate or gain temporary relief, here’s how to prioritize your debt:

Tackle the debt with the highest interest rates first and then work your way down. Make regular payments on the other ones, too, though! When I say tackle, I mean use the strategies above first, and then throw as much extra cash as you can at it ’til the balance is $0.

There’s no magic solution. It’s just good ‘ol buckling down on your budget to look for areas you can save and/or brainstorming ways to increase your income. Disclosure: I’m usually not a big fan of my clients super-budgeting, but when it comes to high-interest debt and high amounts of it…it’s just necessary.

Now, if you have a few different credit cards with debt, and let’s say one is $1,000 and the other one is $10,000, then go after the quick win by tackling the $1,000 debt first. This will give you the motivation to go after the bigger one.

Sometimes, even though one credit card may have a slightly higher interest rate, eliminating the one with the smaller interest rate can be just as effective because the mental exhaustion element of having multiple credit cards can be daunting and cause indifference.

In the example below, tackle the Am Ex first to quickly eliminate it, then move on to paying off the Lowes credit card, followed by Capital One one. You could also attempt to get a balance transfer for 2-3 of the credit cards. I would look into a refinance for the Auto Loan.

Now, most Student Loan Debt has been frozen since the pandemic, and I don’t recommend paying anything while it’s still frozen (no penalty for not paying.) If and when your interest rate comes back, call to try to get that interest rate lowered. But for the most part, low to medium low interest Student Loan Debt shouldn’t take priority over high-interest credit card debt. Learn more about how to approach your Student Loan Debt here.

• Capital One – $4,678 at 24.99%
• Am Ex – $987 at 19%
• Lowes Credit Card – $11,078 at 27.5%
• Auto Loan – $12,076 at 7.99%
• Student Loan – $24,569 at 7%

Remember to keep your monthly minimum payments on the other credit cards/loans so you don’t incur additional penalties and fees!

An Important Note About This Series

It should be noted that this is Step 1 in this series, but building your wealth isn’t always linear. At several points throughout this series, there will be recommendations to work on 1, 2 or even 3 steps simultaneously, depending on your unique situation.

For example, if you do not have an Emergency Fund and you have high-interest debt, you should work towards both until you have at least $3,000 in cash at your checking/savings account. The reason is because when (and notice I don’t include “if” because emergencies are always happening in life) an emergency happens, you don’t want to have to forfeit your debt payoff strategy in place or worse, go into even further high-interest debt.

In Conclusion…

When trying to figure out how to prioritize your debt, these are the steps you need to take:

1. Reframe your mindset around debt (this will pay off in dividends throughout your wealth journey!)
2. List out your debt with interest rates higher than 7%.
3. Take steps to consolidate, find relief (i.e. balance transfer) and reduce your interest rate.
4. Put all your effort into paying off the debt with the highest interest rate, except if you have multiple high-interest loans (typically credit cards) and there is one that is low-hanging fruit, go ahead and take a quick win to eliminate it, even if it doesn’t have the highest interest rate.
5. If your high interest debt is substantial, you must tighten your budget and look for additional income opportunities–there is no magic wand!

Good luck on your debt journey, and if you whether you’re still working on your debt or if you have none, head over to Step 2: Building an Emergency Funds to figure out exactly how much cash you need to keep on hand (Stay tuned!).

This blog post was written on 1/26/23 by Danielle G. Nava, CFP®

​The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All investing involves risk including loss of principal. No strategy assures success or protects against loss.