Good debt, bad debt: how to decide what to repay first

Debt is a tool. Used carefully, it can help you buy a home, finish an education or smooth over a short-term gap. Used carelessly, it can crowd out everything else you want to do with your money. The skill is in telling the two apart and in deciding what to repay first.

This article explains how interest rates and purpose shape the decision, compares the two best-known repayment methods with a worked example, and shows how to think about repaying debt versus investing.

Start with the interest rate

The interest rate is the main guide. Interest compounds against you in the same way that investment returns compound for you. A card balance of 3,000 at an annual rate of 24% costs roughly 60 in interest in the first month (3,000 x 24% / 12). If you pay only the minimum, most of your payment can go to interest and the balance barely moves.

Because investment returns are uncertain and the cost of debt is certain, paying off high-interest debt is often the best guaranteed return you can get. Repaying a 24% balance is equivalent to earning 24% with no risk, which few investments can offer.

"Good" and "bad" debt are rough labels

People often describe debt as good when it builds lasting value, and bad when it pays for something that loses value or is consumed.

• Often seen as constructive: a mortgage on a home you can afford, education that raises your earning power, or a loan to start a viable business.
• Often seen as costly: credit card balances carried month to month, payday loans, and financing for goods that quickly lose value.

The labels are only a guide. Constructive debt can still hurt if the payments are too large for your income or if the asset falls in value. Judge each debt by its rate, its terms, the flexibility you have, and what happens if your income falls.

Two repayment methods

If you have several debts, two methods are widely used. Suppose you have these balances and can put an extra 300 a month toward debt on top of the minimums:

• Credit card A: 2,000 at 22%
• Personal loan B: 5,000 at 11%
• Store card C: 500 at 18%

Avalanche sends the extra money to the highest rate first, which is card A. This minimises the total interest you pay.

Snowball sends the extra money to the smallest balance first, which is store card C. You clear it quickly, which gives a sense of progress, then roll that payment into the next smallest. It usually costs more in interest than the avalanche, but many people stay motivated better with early wins.

Both work if you keep going. The best method is the one you will actually follow. Whichever you choose, keep making at least the minimum payment on every debt, and automate those payments so that none is ever missed.

Ways to lower the cost

• Ask for a lower rate. Lenders sometimes agree, especially if you have a good record.
• Consolidate carefully. Combining debts into a single loan at a lower rate can save interest, but check fees, the new term, and that you do not run the old cards up again.
• Use balance transfer offers with care. A promotional zero or low rate can help, but note the transfer fee and the rate that applies when the promotion ends.
• Stop adding new debt while you are paying it down.

Debt versus investing

When should spare cash go to debt and when to investments?

• High-rate debt: repay first. The guaranteed saving usually beats expected investment returns.
• Low-rate debt: such as some mortgages or education loans, it can make sense to pay on schedule and invest the rest, because the cost of the debt is modest.
• Employer matching: if your employer matches retirement contributions, that match is an immediate return. Many people capture it while also paying down expensive debt.
• Your comfort matters. Some people sleep better with no debt even when the arithmetic favours investing. That is a valid choice.

Protect yourself while you repay

Hold a small emergency fund so that one surprise does not push you back onto credit. Without it, debt repayment can become a cycle in which every setback creates new borrowing.

Common mistakes

• Paying only the minimum on a high-rate balance for years.
• Taking new debt to repay old debt without lowering the cost.
• Ignoring fees and penalty terms.
• Missing payments, which adds charges and can harm your credit record.
• Treating a low monthly payment as proof that a loan is affordable, without looking at the total cost.

A short checklist

• I have listed every debt with its balance, rate and minimum payment.
• I know which debt costs the most.
• I have chosen a method, avalanche or snowball, and automated the payments.
• I keep a small emergency fund.
• I have stopped adding to high-rate balances.

Debt is manageable once you can see it clearly. A written list, a method and steady payments will do more than any single clever trick.