Knowing how to rank your debt can open up new opportunities and improve your credit score
Debt is bad. Paying off your debt is good. That seems to be immutable rule in personal finances with blogs regularly publishing stories of how one couple pays down tens of thousands in just a few months. You don’t need to rank your debt, just pay it off as quickly as possible.
Ok, I’ll drink the Kool-Aid. Too many Americans never achieve financial freedom because of a mountain of debt. The average household owes more than $203,000 on mortgages, student loans and credit card debt.
But unless you’ve got over $200k lying around, one question may be more important than whether or not to pay down your debt. Which debt should you pay off first?
Answering that question means you need to rank your debt.
Rank your Debt according to Rates and Size
The most popular ways to rank your debt are known as the debt avalanche and debt snowball methods. I highlighted these as one of 21 ways to fix your credit score in a prior post, along with an infographic on how to manage each.
The debt avalanche involves ranking your debt by interest rate with the highest-rate debt on top to be paid off first. You make all your minimum payments but make extra payments on the loans with the highest rate until they are paid off. It’s an obvious idea that helps save money by paying off high-interest debt more quickly. You’ll pay less interest over the long run.
The debt snowball method isn’t as well-known but might be the better choice. Instead of ranking your debt by interest rate, you list your accounts from smallest to largest and make extra payments on the smaller debts first. You’ll pay more money in interest compared to the avalanche method but individual debts will drop off much quicker. The idea is that seeing the debts drop off is great motivation to keep saving and paying off your debt. Too many people struggle with their debt plans and need all the motivation they can get to keep on track.
Rank your Debt on Credit Score Factors
Focusing solely on the debt avalanche or snowball methods can miss an opportunity to improve your credit score.
The chart below shows the five factors that contribute to your credit score. Your credit history and amount owed are the largest credit score factors, making up more than half of your credit score. The amount of time you’ve been building credit and any new credit also affect your score.
Ranking your debt won’t change these four factors. You can’t change your credit history and the amount owed is affected by how much you pay, not by which debts you pay off first or last. You can improve your credit score by ranking your debt on the final credit factor, types of credit which accounts for 10% of your score.
The credit bureaus favor non-revolving credit over revolving credit in your credit score. Non-revolving debt is the kind with a fixed payoff date and payments, like your mortgage and car loan. Revolving debt does not have a payoff date and you can continuously borrow more, think debts like credit cards and a home equity line of credit.
The reason why revolving debt reduces your credit score compared to other debt is because you can keep borrowing and quickly get yourself in trouble. Ranking your debt by credit score factors means putting the non-revolving debt on top of the list to pay off first. As your non-revolving debts drop off, your credit score increases and you get access to cheaper credit.
This trick to increase your credit score by paying off revolving debt with a non-revolving loan is one of the reasons debt consolidation is the most popular use of personal loans and peer loans. The idea is that you take out a three- or five-year personal loan through a site like Avant Credit to pay off higher-rate credit. The monthly payments help improve your payment history, the interest rate savings mean lower payments and the better type of debt helps increase your credit score. Peer lenders like Lending Club may offer better rates though you’ll need a credit score of 640 or higher while Avant accepts borrowers with credit as low as 580 FICO.
Rank your Debt on Good Debt, Bad Debt
There is yet another way to rank your debt, one that most people don’t think about but it will give you a whole new perspective on credit. I have been pretty vocal on the blog about the difference between good debt and bad debt. Blindly looking at all debt as bad debt means missing out on some great financial opportunities.
Debt is a financial tool. It can help you build something which wouldn’t otherwise be possible, paying for an education or getting your business off the ground. It’s the use of bad debt, the credit cards and payday loans, that you should avoid.
That’s why I like to rank debt from good debt to bad debt, focusing extra payments on the bad debt to close out those accounts quickly.
Example of a good debt, bad debt ranking (with bad debts at that top of the list):
Some of the ‘bad’ debt at the top of the list isn’t necessarily bad but depends on your interest rate. I regularly use credit cards to rack up rewards points and get thousands in free travel every year. I only charge as much as I have in the bank and can pay off at the end of the month to avoid any interest charges, so it’s really just a 0% loan for a few weeks.
Putting the three ways to rank your debt together means thinking about how they all fit together. You might start by deciding on the debt avalanche or snowball method. With your debts listed according to one of these two methods, think about each account and how it affects your credit score. You might decide to move one of the non-revolving credit accounts higher on the list to pay it off more quickly. You might also want to move some of your bad debt accounts higher on the list, resolving to pay them off and never fall down that rabbit hole again.
However you plan on ranking your debt, continue to make the minimum payments and pay a little extra each month to get out of debt. Whatever you do, stay motivated and know that financial freedom is just a few payments away. Getting out from a mountain of debt can open up a whole new world of choices, from job mobility to better rates on new credit.