Limiting the amount of money you owe to creditors is key to maintaining financial health, but it is equally important to understand how to manage your debts effectively to prevent unnecessary fees and other penalties.
Paying down debt is one strategy to improve your credit score, which can provide more flexibility and favorable terms for future purchases — for instance, if you plan to buy a home in the future, a higher credit score may lead to a lower interest rate on your mortgage.
It is a good practice to pay off all debts as soon as you are able. However, there are certain circumstances that may require you to prioritize certain debts as more urgent than others.
Pay Down High-Interest Debts
Debts that accrue interest at higher rates only become more expensive over time. The sooner you can pay down your balance in high-interest accounts, the better.
High-interest debts can include:
- Personal loans.
- Credit card balances.
- Any other debt with an interest rate higher than 10% APR.
In addition to limiting the amount of interest you will pay, making regular on-time payments to your creditors will have a positive impact on your credit score.
Address High-Priority Debts and Expenses
Failure to pay certain high-priority debts and expenses can have serious consequences that range from financial penalties to jail time. These items should be addressed as soon as possible to avoid further negative effects.
Examples of high-priority debts and expenses include:
- Court judgements. If you have been sued on a debt and the court rules in the creditor’s favor, the creditor is legally entitled to seize your wages, bank accounts and even your home or other property if your debt is not paid in the agreed upon terms.
- Criminal justice fees and fines. Non-payment of debts arising from a criminal proceeding can lead to immediate loss of your driver’s license, loss of income or assets, or even incarceration.
- Automobile loans or leases. Falling behind on payments for your auto loan or lease can result in the creditor repossessing your vehicle. This is an especially high-priority debt if you rely on your car for transportation to work or other essential functions.
- Child support. If you have been ordered to pay child support, you must keep up with payments or risk facing further legal penalties, including prison.
Although they may be less immediate, there are other debts and expenses that can become a high priority if you miss payments for an extended period. These include:
- Mortgage payments. If you fall behind on your mortgage payments, your servicer may be willing to work with you on a forbearance or repayment plan. However, if you fall several months behind, you may risk losing your home to foreclosure.
- Rent payments. Failure to pay your rent can result in eviction.
- Utility bills. Non-payment of utility bills can lead to termination of your gas, electric, water or other utility services.
- Federal student loans. If you are more than nine months late on your federal student loan payments, the government may seize your IRS tax return or wages and may add collection costs to your debt. This can also result in the denial of any new student loans and grants.
- Taxes owed to the IRS. Even if you do not pay federal income taxes when due, you should always file your tax return on time, or file it by the deadline of any requested extension. Failure to pay your federal taxes can lead to seizure of your bank account, part of your paycheck, federal benefits and even your home.
For more information about managing your finances, learning debt reduction strategies and preparing for homeownership, visit CreditSmart® Essentials by Freddie Mac, a flexible, customizable and free online course — also available in Spanish.