This week I want to tackle another great question from one of our community members:
“What’s the best way to pay off loans when you have a few? We have a mortgage, a car loan, and a couple of credit cards. Should we consolidate all loans into one, or should we start with the smallest first?”
Well, the answer is as easy as A, B, C…
A. Start Small
Behavioural psychologists suggest that paying off the smallest debt first will make you feel like you are making progress, which should encourage you to keep soldiering on! So if you have multiple credit cards, start with the smallest and keep going!
B. Let the interest rates be your guide
When we bring a mortgage and a car loan into the credit mix, in general the interest rate should guide you – pay the loans with the highest rates first:
- Your mortgage is secured by your home, and is the lowest interest rate of the three.
- Your car loan is secured by your car and the interest rate will typically be 2-3% higher than your mortgage.
- The credit card is an unsecured loan. That means that if you default on the debt the bank can’t come and take your possessions to pay it off, so you will typically be paying around 14-17% interest (or higher when you use the cash out option on your credit card), and the same typically goes for personal loans.
Debt consolidation is where you bring all your loans together, and may be worth considering if you own a home. Consolidating all your loans into your mortgage can be a good option because you can access a lower interest rate on the previously higher interest rate loans. But there are a few things to keep in mind:
- When you consolidate in this way, you are effectively taking an unsecured loan or a car loan and securing them against your house. So if for any reason you are unable to pay off this debt, your house comes into play as potential collateral.
- By consolidating you are taking a short term debt (e.g. 5 year car loan) and spreading it out over 30 years. If you stick to the minimum repayments, over the long term you will be far worse off, so make sure to keep up with your usual repayment amount (or more) while taking advantage of the lower interest rate.
- Make sure you close off each credit card as you go, otherwise consolidating can be a surefire way to double your credit card debt!
- If your car loan is in the form of a lease (a type of car loan), the early repayment and exit fees may outweigh any saving you stand to make by consolidating. Be sure to first contact your loan provider to check the costs involved in paying out the car loan early.
- Take advantage of the option to have a split on your mortgage between the home loan and multiple consolidated loans so that you can see each portion of the debt separately. That way you can work to pay the consolidated debt off as quickly as you can.
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