Which Debts Should You Tackle First?

Then there's the issue of how to prioritize your bills. Often borrowers are advised to figure out which of their debts have interest that's tax-deductible, and to pay those last. They're told to concentrate on paying off the highest-interest-rate, nondeductible debts they have, while paying the minimum on other debts. Once the high-rate debt is paid off, they're told to apply the same payments to the next-highest-rate debt, in a process known as “snowballing.”

In some cases, though, it can make more sense to pay a lower-rate debt first, or even a deductible debt before a nondeductible one.

Ginny owed $30,000 in student loans at 5% interest as well as $35,000 on her home equity line of credit, which hovered around 4%. Her income was too high to deduct her student loan interest, but her credit line payment was a write-off. The conventional wisdom would have her pay the student debt first.

But student loans have a feature not common to most other debt: You can get a forbearance (a temporary suspension of payments) that allows you to skip payments while you're unemployed. Since Ginny works in an unstable industry, she resolved to pay down the home equity line first so that she could use the freed-up amount of credit again in an emergency.

The key to managing your debt wisely is knowing which debts are helpful to you and which will leave you worse off. You need to figure out how much debt you can realistically take on so that you don't swamp your financial ship. You need to know when to accelerate your payments and when to pay the minimum. In short, you need to look at debt as a key part of your financial plan, rather than as a scourge that can and should be erased from your life.

Ultimately, being debt-free is a great way to be. But you want to get there the smart way.