In the process of paying all of a person's debts, knowing which ones to prioritize is absolutely essential. The question is, how would one know which debt to pay off first?
Essential debts
A essential debt is one that needs to be considered top priority. Essential debts, when left unpaid, would render serious consequences, because these comprise an individual's basic and necessary needs. More often than not, these debts are secured debts, or debts that require property or collateral to guarantee payment for the loan.
Mortgage is an example of essential debt. Putting it simply, making payments to keep a roof over one's head are absolutely essential. If an individual is not able to keep up with their monthly mortgage payments, they may lose their home due to foreclosure. When a foreclosure occurs, a debtor's house is sold by the mortgage lender or another creditor. The funds generated from selling the house are then used to pay for a debt, or debts, that the consumer owes.
One alternative to be able to continue maintaining mortgage dues each month is to look for a roommate who can help you with the payments. Another alternative is to negotiate with the mortgage lender to temporary reduce the costs that an individual is required to pay each month. Mortgage lenders usually have payment plans or “mortgage workouts” that allow debtors to stay financially afloat and maintain their home at the same time. By immediately contacting the lender, a person will have more options to take care of the delinquent loan, and in effect, prevent the house from being foreclosed.
In the same way, making sure to regularly pay for home equity lines of credit (or second mortgages) are of utmost importance, because defaulting on these payments can also lead to losing your home.
If a debtor currently does not own a home, rent is definitely another top priority debt. Obviously, defaulting on rent will result in getting kicked out from your living quarters. If you think you're unable to take care of rent dues, immediately inform your landlord or landlady about the situation. It is essential for a tenant to obtain a written confirmation from their landlord in reference to the arrangement that they would like to set up. An individual may ask for a temporary rent reduction for the time being. Explaining your current hardship and giving your landlord the assurance that you would be able to give them the original agreed amount is enough to justify the request that you would wish to make. A person may also wish to moving into a less expensive (not to mention more budget-friendly) unit. They may also offer their services in providing certain services, like cleaning, plumbing, or gardening, or doing repairs, in exchange for the reduced rent.
Utilities are imperative, aside from an individual's living conditions. The list of utilities includes electricity, gas, water, a telephone, and heating oil. Losing any one of these is hazardous.
Child support is also another example of an essential debt. The inability to make the needed payments for child support is a punishable by law, and an individual who forgoes their obligations will be imprisoned. The funds that a debtor's children are receiving are important for them to be able to meet their needs. If an individual is unable to meet child support requirements, they can apply for a reduction of this obligation. Certain legal justifications that the court can accept for a change in support include: a significant decrease in the supporter's income due to unemployment, for example; increased expenses, such as the birth of a new child, or a current medical condition requiring expensive maintenance and procedures; or a decrease in the recipient’s needs.
Another priority debt that an individual needs to watch out for is their monthly car payment. This also includes the processes that entail maintenance of the car. Having an automobile may seem as a necessity, but when the going gets tough, you may have to let go of it. Some employers require that their employees acquire or utilize their own vehicles; if this is the case for you, it's absolutely a must to make those payments. However, if a vehicle isn't exactly a job requirement, an individual can opt to sell the car. Selling the vehicle also enables an individual to purchase a cheaper vehicle.
Defaulting on car payments may result to repossession. When an item is repossessed, the borrower has to voluntarily return the item that they borrowed—in this case, the car—to the original lender or the party having the right of ownership to the item. As opposed to a foreclosure, the debtor has the obligation to return the automobile to its rightful owner. Aside from that, the lender will sell the automobile for a mere fraction of its actual value, and the borrower still has an obligation to pay for the difference between the actual amount of the property and the amount for it was sold.
An individual cannot just sell a motor vehicle if they are leasing it. In this scenario, the borrower needs to get in touch with the leasing company from where the car came from, and request for a pre-termination of the lease contract. There may be some fees that need to be paid, such as an early termination penalty fee and past due payments that were incurred. Usually, the pre-termination fee is quite hefty, but it gives the borrower freedom from the monthly obligations that they need to make with the company.
If an individual chooses to keep the car, part of the responsibilities that they need to fulfill is maintaining the vehicle. Having a car also means having automobile insurance. Making sure that the insurance payments are up-to-date is necessary. Being unable to keep up with the car's monthly insurance payments will also be considered as grounds for repossession. When a lender sees that the borrower is unable to maintain his car insurance, it is considered to be an “event of default.” The lender may also opt to acquire insurance in order to protect its interest in the car. When this happens, the borrower is held responsible for the premiums that need to be paid, and these are usually quite pricey.
Another debt that needs to be taken into consideration is unpaid taxes. In essence, the IRS has the ability to seize and confiscate an individual's personal property—namely their home, bank account, automobile, and even your paycheck. If a person has any unsettled dues with the IRS, they need to set up a payment plan with them as immediately as possible. One is eligible for repayments done in an installment basis if:
• The amount owed is $10,000 or less
• The individual has a good payment record for the past five years. If they have faithfully and consistently fulfilled their obligations with the IRS, like paying income taxes and filing returns on time.
• The individual has not applied for an installment within the aforementioned five-year period.
• The IRS can vouch for the fact that the individual cannot pay for the full amount of taxes that he or she currently owes.
• The individual agrees to pay for the full amount of the loan within a three-year period.
Non-essential debts
Non-essential debts, on the other hand, do not have debilitating, long-term effects upon failure of payment. While these debts are also a must to take care of, payment of these debts is not as immediately crucial as the essential debts.
A credit card is generally considered as a nonessential debt. Credit cards are often stressed as important and are even deemed a necessity. Credit card debt collectors may even get on a person's hair in order to collect on the debt incurred. The truth is, the worst thing that can actually happen is the ability to losing one's credit privileges—meaning, there are higher chances of having difficulty in gaining additional credit, or applying for a new loan.
It is important to note that an individual needs to keep at least one credit card current, in case of emergencies. This allows them to still be able to charge on the card when unforeseen circumstances occur. If this is the case, and your budget is really tight, paying for the monthly minimum—or more than the minimum--on the card can help, but only for the short term. The ultimate goal, after all, is to cultivate a debt-free life.
Some lenders have started adopting the practice of charging customers with higher-than-usual interest rates after seeing other delinquencies on the customers' credit reports. This method is basically a way of protecting themselves from “risky” cardholders. This is very likely to happen, even if an individual has never made a late payment to their most recent credit card application.
Store cards such as department store cards and gas cards are also counted in the list. Much in the same way as credit cards function, an individual who defaults on these cards run the risk of losing credit privileges. Over time, the lenders may also sue borrowers who do not repay their debts. The same goes for publication subscriptions. When an individual's magazine or newspaper subscription runs up on debts, there is likelihood that subscriber may be sued after an extended period of nonpayment.
Personal loans from family and friends may seem to be an obligation. If funds on your end are really tight, however, and you are unable to pay them back in the soonest possible time, you need to ask them if you can delay the payment with them. Usually, they are the most understanding with you.
Legal, medical, and accounting bills are important but not generally considered as essential. This does not apply if, for instance, an individual is currently going through medication. Defaulting on this bill may hinder him or her from obtaining the necessary prescription drugs that they need.
Deeming these debts as “non-essential” does not mean that these debts are to be completely neglected altogether. Keep in mind that a judgment, or a court-issued decree filed by a creditor against a debtor, may turn a supposedly harmless non-essential debt to an essential one. Simply put, the creditor will utilize all means to get their money back, and they can take a portion of an individual's property or wages if they are unable or do not pay what is due.
Other methods
This article may have stressed the importance of essential and non-essential debts, but there are also other alternatives that exist that can also determine how to prioritize an individual's debts.
The debt snowball approach
One way to prioritize debt is by the debt snowball approach. This method is best used with unsecured debts such as credit cards, personal loans, and other loans that do not require collateral for this to be paid off. An individual starts using this method by making a list of all his available debts, taking note of the bills that have the smallest balances. The debt snowball approach stresses the importance of paying off these bills first, while making minimum payments on the debts that have much higher balances. Paying for the minimums on the other bills allows a debtor better leeway to be able to concentrate paying off the smallest bill first. After being able to pay off the smallest bill, the debtor moves on to the next bill, working to pay it off, and applying the minimum payments that were made to the other bills towards the current bill to be paid.
For example, if Deborah has three balances due:
Name of loan Balance Interest rate Time period Monthly minimum due
Medical bill $8,500.00 5% per annum 5 years $160.41
Bank of Alabama credit card $3,500.00 3.75% per annum 5 years $64.06
GXY Bank credit card $2,500.00 $4.5 per annum 5 years $46.61
If Deborah chooses to use the debt snowball method, she will need to pay off her GXY credit card first, because it has the least amount of balance. She will then continue to make the minimum payments due on her two other loans.
When Deborah has paid off the GXY card off in full, she will then proceed to apply the amounts of payments that she's made from GXY to her Bank of Alabama card, amounting to at least $110.67 monthly. The same goes for the rest of the remaining debts, until all of them have been paid off. The process creates a “snowball effect.” As a snowball tumbles down a mountain, it gets bigger and bigger as it accumulates more debris; the same principle is being applied to paying off an individual's debts.
Dave Ramsey, a well-known financial adviser who is a major proponent of the debt snowball method, believes that this is the best method for debt elimination. The principle applies to human nature; the results are more visible, and this encourages people to keep on saving and working to pay off the debt. Ramsey's approach also targets an individual's specific behavior towards financial management. There is a quicker progression in paying off debts, as momentum to pay off loans is built, as little by little, more and more loans are paid off. Ramsey also encourages paying less in order to save up for rainy days and emergencies that may come up in the process of paying off loans.
Highest interest first
Another debt reduction plan is by paying off the debts that have the highest interest rates first. It also entails listing down all available debts and arranging them, albeit with the ones with the greater interest rates on top of the list. While the previous approach leaned towards being more consumer-oriented, this method is more effective from a financial standpoint. It allows the debtor to have less to worry about, and more to pay down on the next debt that he has to take care of.
Suze Orman, another renowned financial adviser who highly endorses the use of this payment scheme, also advises to pay more than the minimum amount due on each loan. Doing so greatly reduces the balance on the loan, and at the same time allows for lesser upcoming payments due. At the same time, paying off the loans with the higher balances first enables an individual to pay off his loans in a much faster rate. While the results of his efforts would not be as easily and readily visible as the debt snowball approach, a person can actually save more money towards interest payments in the end.
Whichever method you choose between these two modes of payment, remember to stick to your plan, and keep on keeping on until the goal of debt elimination is reached!
Something to remember
There may be a lot of options for individuals on taking care of their debts, but at the end of the day, choosing which system to apply towards your current financial state is completely up to you. It always depends on how you are best able to take care of these obligations without completely letting go of other things that matter. After much hard work, patience, and the right perspective, success is sure to come through, every time.