Deputy Editor Janet Bodnar answers questions about debt prioritization.
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Interviewer: What debts should I pay off first? Janet Bodnar: Well, there are two ways of figuring out which debts to pay off first. There's the mathematical way, and there's the psychological way. The mathematical way is: which is your most expensive debt? Which is the debt that has the highest interest rate? Likely as not, that's going to be your credit card debt, and that's the debt you really should pay off first. There's also a psychological factor here. Sometimes you have a lot of accounts where you owe just a little bit of money, maybe $100 here, $100 there. The interest rate isn't all that high, but you just want to get those accounts paid off. So another strategy would be to pay off the accounts that are the smallest ones first, because it gives you that psychological feeling of satisfaction. Interviewer: Should I make paying off my mortgage my debt priority? Janet Bodnar: No. Certainly not when you've just taken out a mortgage. Generally speaking, your mortgage loan is going to be one of your lowest rate loans. So what you really want to do is go after the higher rate loans first. Paying off a mortgage is not really a priority early on. Also, because it's not going to lower your mortgage payment, you can probably take the money that you would have paid on the mortgage and use it better elsewhere. Funding your retirement account, for example. You can probably get a better return on it than you can by just simply paying off the mortgage. There are lots of reasons not to pay off your mortgage early on. Again, you have too much money tied up in your house. When it does make sense to pay off your mortgage is when you're toward the end of the loan. You're getting ready for retirement, for example, and you really only have a little bit left on your loan. Again, you just want that satisfaction of not having that mortgage monkey on your back. You just want it paid off and done with. But that would be later in the term of the loan. Interviewer: What are some examples of bad debt repayment strategies? Janet Bodnar: Well, one bad debt repayment strategy would be to go for your lowest-cost debt first. What you really want to do is prioritize the high-cost debt, the credit card debt, not the mortgage debt, not the student loan debt, which is also relatively low-cost. What you want to do is go for the highest cost first, not the lowest cost. Another bad strategy would be to go for a consolidation loan that actually gives you a higher interest rate than you're now paying. If you're going to consolidate your loans into one, the whole idea should be to get a lower rate than you're paying now, to help you make the payments. You don't want to make things worse. Interviewer: Should I pay off debts rather than put money into my savings? Janet Bodnar: I think you should alway go for putting money into savings. If you just have a limited amount of money, you should divide it up into paying off debt and savings. Yes, paying off debt is really an important thing to do, but again, there is always a pyschological satisfaction in having money in the bank in case the roof leaks or in case the car breaks down. Also, you might want to start funding your retirement plan at work, especially if your employer is going to be matching that money that you're putting aside. That's really a hundred percent return that you're making on that money and you don't want to turn aside free money. So again, if you have a limited pot of money to use towards savings and paying down debt, I would try to divide it up.