Debt Priority: Which Debts Should You Repay First?

Is your car more important than your home? You might be surprised to hear that, yes, in certain circumstances, you need your car more than your current home, and therefore should pay a car loan before a home loan (for the short term at least). Debt priority, that is, which debts you should repay first, is an important strategy for those short on cash and long on debts.

There are debts which you absolutely have to pay and those which you may be able to delay until you can better afford to pay them. If you know you have limited funds with which to repay your debts, you'll need to make a list of debts. Then prioritize them from most to least important. All debts should be repaid, of course, but the reality is that in this economy, many people are over their heads in debt, and the goal of debt prioritization is to keep the water below the neck.

There's no cookie cutter formula to creating a debt priority--they will be different according to the individual, so you'll need to objectively analyze your situation to create a debt repaying strategy that works best for your circumstances.

Debts to Pay First
Failing to pay certain debts can have an obvious, immediate, and negative impact on you and your family. When creating a debt priority strategy, think of these types of debts as having long-reaching consequences to your future, through damaged credit scores and reduced chances of future lending.

Taxes and liens against property. If you're in trouble with the IRS, you must take care of it--not only because of the compounding interest (which can skyrocket) and penalties, but because the IRS wields enormous power when it comes to collecting its due. The IRS can seize bank accounts and assets to collect its money from you and garnish your wages, all of which can lead to you being unable to repay other debts or sustain your lifestyle.

Rent and Mortgages. Apart from the obvious of losing the physical roof over your head, losing your home or apartment can cause serious emotional harm to you and your family. It's a shock from which many people take a long time to recover. The immediate effect is potentially losing the home, and the future ramification is that it will become more difficult to find future housing. If you fear you're going to fall behind on mortgage payments, contact your lender and see what kind of arrangements can be made to reduce your payments.

If your house is simply too much for your budget, you should consider moving out and downsizing your current living arrangements. However, selling and getting full value for your home (or at least the price at which you purchased it) is unlikely during this prolonged housing crunch, so be ready to continue making mortgages payments if you can't stand to part with your home for an undervalued price. On the other hand, staying in a home that you can't afford until the bank forecloses is obviously much worse for your financial future.

Car loans. If you need your car to get to and from work, or for other essential needs, you will want to stay current on your car payments. If you're in a situation where you need a car to go to work, but you have a mortgage you can't afford on a home that's probably too big for you, the car is more important to your financial security than the home. Make efforts to downsize your living situation.

One the other hand, if you don't need your car for essential purposes, you should consider selling it. While you probably won't get nearly as much as you paid for it (a car depreciates substantially the moment you drive it off the dealer's lot), you can use the money from the sale to pay off the loan and have some money left over to pay other bills or get a cheaper car. Car loans are the types of debts which are unique to each individual. To some they're essential, while to others a car is a luxury.

Child support. Failure to pay child support can lead to arrest and prison. You don't want to go to lose your freedom over money. Depending on what state you live in, the penalties for failing to pay child support can also include wage garnishment and the loss of your driver's license.

Utility bills. Losing hot water, heat or electricity is traumatic and dangerous. They are staples of a normal, healthy life and you should do everything within your power to avoid their loss.

Bills That Can Wait
While the repayment of the above debts are necessary to continue leading healthy and productive lives, there are other debts which either don't rise to a "life and limb" level or can be negotiated more easily with lenders. That's not to say that nonpayment of these debts won't hurt you financially, but they are debts which fall low on the debt priority list. The goal is to target the most important debts first.

Credit card bills (including department store cards). While credit card bills are the largest source of debt in this country, the good news is that they feature (fairly) low minimum payments. While the interest rates will increase your debt load, you won't face losing your home or going to jail for nonpayment. Try to at least make minimum payments on your credit card debts and start making larger payments when you have more financial freedom.

Student Loans. Most student loans, particularly ones derived from government sources (e.g., Direct Loans), are much more lenient about late payments and making different financial arrangements based on your financial needs. They may allow you to suspend making payments for a certain period (interest accumulated during the period will compound, however) or allow you to reduce your payments.

Any other unsecured debts. As long as you haven't put up collateral (e.g., property such as a home, a car, etc.) to get a loan, the debt is unsecured, meaning creditors can't take anything from you. They can sue of course, but they can only sue for what you owe them, which you're going to have to pay anyway. The point is that you're not facing the loss of anything critical to your survival, so these debts fall to the bottom of the debt priority. Examples of unsecured debts are legal bills, medical bills, and other service related bills.

The Special Case of Insurance Bills
Insurance bills fall into a grey area of personal needs and certain state laws. Insurance protects you against losses, but the personal question becomes, is it worth it to you and/or is there a state law which requires the insurance?

For example, if you in a state other than New Hampshire or Wisconsin (the only two states that don't require auto insurance), and you need your car, than obviously paying your auto insurance premium becomes an essential debt to pay.

If you have medical insurance that is about to lapse and you have a condition that requires hospitalization or specialized treatment, then paying that bill also becomes essential. If you allow your health insurance to lapse and you have a condition, obtaining new insurance in the future becomes more difficult because of your pre-existing condition.

On the other hand, if you're healthy and absolutely cannot afford your health insurance, you may find dropping your coverage to be an attractive risk. Insurance is unique to the individual and should be considered carefully for your debt priority list.