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Business // Thinking Smart
David S. Chang

Which Debt To Pay Down First

The average American household has $15,325 in credit card debt, $147,924 in mortgage debt and $32,041 in student loan debt. How to pay your debt is important (visit artofthinkingsmart.com for more information), but which debt to pay off first is just as important if you are unable to pay off all of them at once. It may make sense to pay off the debt with the highest interest rates. But if you are looking to raise your credit score, paying off certain types of debt over others can get you the best credit score value. There are two types of debt:

* Installment debt has a fixed payment for a fixed period of time. A mortgage or car loan are common examples. In some cases, an asset secures the debt. Other types of installment debts are student loans and unsecured personal loans.

* Revolving debt allows you to pay a partial or all of the amount each month rather than a fixed amount. Credit cards and Home Equity Line of Credits (HELOCs) are the most common revolving loans. Unlike an installment loan, you have access to the line of credit even if you have paid the full balance.

If you have both types of loans, which one is the best one to pay off first?

* Since many installment loans are collateralized, they pose a lesser risk to the lender, since, if you default, they can repossess the asset backing the loan. The lender can sell that asset (many at an auction) to cover as much of the loan balance as possible. Installment loans also have tax benefits where the interest is deductible. As a result, the impact of installment loans to your credit score is minimal, so the credit score benefits from paying off your installment loans also are minimal.

* To lenders, revolving debt such as credit cards is more indicative of future credit risk. It is unsecured, so there is no collateral for the lender. Also, since you won’t lose your house or car if you don’t pay your credit cards, it generally is a lower priority to pay if you run into financial problems. Currently, the average credit card interest is approximately 15 percent and installment loans around 5 percent, so revolving debt interest is much more expensive. As a result, credit card debt can have a greater negative impact on your credit score. On the flip side, paying off your credit cards can have a greater positive impact on your credit score, so paying off revolving debt first may be more beneficial.

* Although some installment loans, like student loans, are not collateralized, they still pose less risk than revolving debt. FICO states, “It’s important to understand that while student loan debt can factor into the FICO Score, revolving debt has a larger influence. That’s because we’ve found that revolving type indebtedness has a stronger statistical correlation with future borrower performance than installment loan indebtedness.” VantageScore also says, “Generally speaking, paying down credit card debt can be more beneficial to a consumer’s credit score than paying down an installment loan, because it reduces the total amount a consumer owes as well as the percentage of credit used, thereby increasing the amount of credit available to that consumer.”

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