Learn how to prioritize debts

Learn how to prioritize debts

The complete guide to life without debts - Step 2

23 June 2015

In order to deal with debts wisely, you must prioritize them: decide which is the most important debt to start with.

When there are many debts it is hard to know which is the most important to start with. Here are guidelines you should consider while prioritizing your debts:

Monthly repayment level in relation to the loan balance left

This information will help you realize which of your loans casts a burden on the monthly repayment needed for the entire debt and may be a candidate for loan refinance/restructure. For that, you need to analyze the ratio between the total monthly repayment sum and the loan sum. That ratio (percentage) indicates the “load” that the loan creates on the monthly budget. The higher the “load” the higher the priority for this loan to be dealt with first.

For example:

Let’s assume there are two loans:

The first, 5,000 Shekels, to a credit card company, without interest, and a monthly payment of 1,000 Shekels.

The second, 45,000 Shekels, carrying 8% interest, and a monthly payment of 1,000 Shekels.

How do we calculate the ”load” of each, so that we know which one to take care of first?

In the first loan, the “load” is 1000/5000=20%

In the second loan, the “load” is 1000/45000=2.2% (about).

It is easy to conclude that the “load” of the first loan is by far bigger than that of the second one; therefore, considering the “load”, dealing with the first loan is by far at a higher priority.

Interest rate

In the above example, the second loan is at a higher interest (8%), while the first loan has no interest at all. Does that indicate that the second loan is less economically feasible, and actually this needs to be the loan at a higher priority to deal with?

Interest is indeed another factor that should also be part of the priority scheme. The higher the interest, the more we pay to repay the loan so in most cases we will want to handle the higher interest rate loans first. However, interest rate will always be secondary factor in the process of debt settlement.

The primary factor is the monthly repayment level and the “load” it causes.

Does the loan have underwriters?

There are two possible approaches when a loan has underwriters. The decision about which approach to choose depends on who are the underwriters and what is your direct relationship with them. At any rate, each approach you choose must be in full cooperation with the underwriters.

The first approach is to give higher priority to loans with underwriters, so that the creditors/lenders will not turn to the underwriters for collection.

The second approach is to consider the underwriters as a helping factor regarding the debt. Meaning, they will carry the payment burden for you, and you will repay them according to your payment ability.

The impact of payment deferral

What will happen if you fall behind on your payments, producing a backlog?

If we are talking about debt to family members or friends, the impact could turn cozy relationships of trust and agreement into uncomfortable situations which could lead to deep family arguments, unbearable conflicts, and long-term feuds.

Sanctions as a result of payment deferral

Sanctions can be imposed as a result of falling behind on debt payments. The type of sanctions and their impact will influence the priority of the debts. For example, falling behind on a municipality debt can lead to repossession, and stopping payments to authorities (like VAT) is even considered a criminal offense.

You must check thoroughly which of the debts may lead to legal proceedings if they are not dealt with at a higher priority. Settling debts that are already in legal proceedings is more complicated and much more expensive.

Protecting possible sources for an additional loan

Sometimes there is a need to take out new loans in order to repay current loans. Take note if there is anyone from your current creditors/lenders who may become a source for new loans, and consider that in the priority ranking. This way you can protect potential sources for additional loans. If, for example, you consider taking out another mortgage, it is essential that you are current with your existing loan payments. Even one late payment may be a reason to be denied another mortgage.

Setting priorities according to the above guidelines will organize your depts. – and at the end of the process you may start seeing the light at the end of the tunnel. So, what do you do after your prioritize your debts? Move on to the next chapter – calculating your repayment ability.