Which debt should you pay off first?

Is there one right order to pay off debt?

No. There are two orderings people commonly use, they trade different things against each other, and which one suits a person depends on their own situation and what they find sustainable.

Both orderings assume the same starting point: the contracted payment on every debt keeps being made, and anything spare goes against one chosen debt. The difference is only which debt gets the spare money.

Paagaa is not a licensed financial advice provider and cannot tell you which ordering to use. What follows is how each one works so the choice is yours to make with the mechanics in view.

How does paying the highest interest rate first work?

You keep making the contracted payment on every debt, and put anything spare against whichever debt charges the highest annual interest rate. When that one is cleared, the money it was absorbing moves to the next highest rate, and so on. Some people call this the avalanche method.

The trade this makes is mathematical. Interest is charged on the balance you still owe, so a dollar removed from a high-rate balance stops more future interest than the same dollar removed from a low-rate balance. Over the whole run, this ordering costs the least interest of any ordering.

What it gives up is visible progress. If the highest-rate debt also happens to be a large one, it can be many months before any individual debt disappears from the list, and some people find that hard to sustain.

How does paying the smallest balance first work?

You keep making the contracted payment on every debt, and put anything spare against whichever debt has the smallest remaining balance, regardless of its interest rate. When it is gone, the money moves to the next smallest. Some people call this the snowball method.

The trade this makes is the other way around. Because the smallest balance clears soonest, the number of separate debts drops earlier, which means fewer payments to track and one less creditor to deal with. For someone who is finding the process discouraging, that matters.

What it gives up is interest. Where the rates on the debts differ, paying the smallest balance first will cost more in total interest than paying the highest rate first, and the gap is wider the bigger the difference between the rates.

What has to happen under either ordering?

The contracted payment on every other debt still has to be made. Both orderings work by directing surplus money, not by pausing anything, and a missed contracted payment can trigger default fees, be reported to credit reporters, and on secured lending start a repossession process.

If the contracted payments themselves are not affordable, then neither ordering is the question in front of you. New Zealand law gives borrowers a right to apply to a lender to change a consumer credit contract on the grounds of unforeseen hardship, and free financial mentors can make that approach on your behalf.

Do all debts in New Zealand charge interest?

No, and that changes what the orderings mean in practice. Inland Revenue does not charge interest on a student loan while you are a New Zealand-based borrower. Interest is added once you become overseas-based, and Inland Revenue sets that rate at the start of each tax year on 1 April and publishes the current figure.

Buy now, pay later instalments generally do not charge interest either, but they do carry default fees if a payment fails. A debt with no interest rate still has a due date, and the cost of missing it is a fee rather than an interest charge.

Inland Revenue does charge late payment interest where student loan repayments fall behind, and it can also set up an instalment plan for the overdue amount. That is a separate arrangement from a lender's hardship process, and the current rates are published on the Inland Revenue site.

Does it matter whether a debt is secured?

It changes what is at stake if payments stop, which is a different question from what a debt costs. A secured debt is one where something you own stands behind it, such as a house behind a mortgage or a car behind a finance agreement.

Where consumer goods are secured, the lender has to follow Part 3A of the Credit Contracts and Consumer Finance Act before repossessing, including sending a repossession warning notice. An unsecured debt, such as a credit card balance or a personal loan without security, cannot take the goods, though it can be sent to collection or pursued in court.

Some people take account of this alongside interest rates when deciding where spare money goes. It is one more factor rather than a rule, and how much weight it deserves depends on your own circumstances.

What if there is no spare money to direct at all?

That is a common situation, and it has its own set of options rather than being a failure of either ordering. A hardship application under section 55 of the Credit Contracts and Consumer Finance Act asks a lender to extend the term or postpone payments so each payment is smaller, and the lender has to acknowledge it within 5 working days and decide within 20.

MoneyTalks provides free, confidential financial mentoring at https://www.moneytalks.co.nz/ or on 0800 345 123. Mentors negotiate with creditors on people's behalf and help prepare hardship applications, and there is no cost and no income test.