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Which Debt to Pay Down?

Chris Farrell Sep 10, 2008

Question: My parents gave me a check to help with debt reduction. I am somewhat overwhelmed with the possible uses for this check. I have a loan with 12% interest which would be close to being paid off with their check; a credit card at 0%; and credit card at 10%. My first instinct is to pay off the loan and be nearly done with my 2nd highest monthly payment. However, credit card debt is less favorable to my credit than a loan. I also wonder if I should split the payment and pay off some debt and put the rest into a 2-year CD? Or finally, much needed home repair that I could pay up front rather than financing. What’s best: loan repayment, credit card repayment; repayment and savings; or home repair? Kate, Minneapolis, MN

Answer: In a sense you can’t go wrong. But there are trade-offs, and that’s where the paralysis comes in. Here are some ways to think about it.

The standard advice–with good reason–is to attack the high interest debt first. By definition, it’s the most costly. However, all of us need some positive reinforcement and there is a “whew” factor to consider when we finally get rid of a debt. That’s why it can make sense psychologically to attack the debt with the smallest amount due even if financially the logical course is paying down the high interest rate debt.

Now, reminiscent of the fierce debate over whether to tie a kid’s allowance to household chores, either approach has passionate advocates. I fall in the agnostic camp. Either way, you’re getting rid of debt. The real question is, which approach will work best for you? Paying off a loan or tackling higher rate debt?

That’s one big issue. The other one is the home repair. You say it’s “much needed.” I interpret that to mean the repair will help maintain the value of your home. I know that the housing prices are falling now and for the foreseeable future. But over a longer period of time your house is a major investment. In that case, using the money from your parents as investment money, and setting up a debt repayment plan to attack your other debts, seems sensible to me.

Last, understanding how you got into debt in the first place and how you plan to stay out of debt once you get all your debts paid off. Part of this process is the proverbial “know thyself” and part of it is creating a practical budget you can and will stick to over time.

So, with all this in mind, here is how I would approach it.

If you haven’t done so already, take the time to make a realistic budget for paying off your (remaining) debts. Next, while in most cases borrowing to make home improvements is good debt that should pay for itself over time, it might be the best course to avoid taking on new debts. This way you can get your home fixed up, and focus on your debt reduction plan.

Does anyone have another thought or approach?

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