What Debts to Pay Off First?

Being in debt is difficult, but owing money to several creditors at once can seem treacherous – especially if one of those creditors is the IRS. Unfortunately, getting out from under that mountain of debt is rarely easy. Aside from the struggle to actually pay the amount owed, debtors must also prioritize which creditors are worth devoting the most money and attention to. If you aren’t careful, vastly different debts (back taxes, student loans, gym memberships, etc.) can all blur together into an indiscriminate mass of “all that money I owe people.”

The fact is that not all creditors see your debt in the same way or have the same authority to punish you for failing to repay. The consequences for not paying years of back taxes, for example, are much more serious. It’s best to repay all debts as quickly as possible, on general financial principle. But nevertheless, it is worth exploring some important differences between various types of creditors, including the order in which you might want to prioritize repaying them.

Debt Priority #1 – Taxes

Write it on your forehead and repeat as needed: the IRS always gets its money first. No matter how many people you owe (or how much), delinquent taxes take precedence. For one thing, the IRS is the only creditor capable of imposing fines or sending you to prison for failure to pay. Granted, not all are sent to prison. But the very fact that the government can, if it so chooses, take away your freedom for unpaid tax debt suggests that this should be your number one repayment target. In fact, you may not have a choice. If you owe money to several creditors, the IRS (by imposing tax liens) is automatically first in line to collect on any assets you possess that can help satisfy its claims. Even banks and mortgage lenders have to wait in line behind the feds. Additionally, prison is hardly the only penalty the IRS can impose. A far more common punishment is the levying of fines and interest on the full amount of taxes you owe. The IRS can also garnish your wages. Generally, if you have a seriously delinquent debt, the IRS can issue a debt certification and the State Department will not issue passports to taxpayers after receiving their debt certification. The State Department may also deny a taxpayer’s passport application or revoke their current passport. 

Finally, do not assume that the IRS has “forgotten” about you or that you’ve “gotten away” with not filing returns or paying for several years. The IRS is backlogged, but all non-payers and non-filers are logged in their computer systems, and it is only a matter of when (not if) you are pursued with audits or penalties.

Debt Priority #2 – Your Mortgage

Slightly less foreboding than the IRS are banks and mortgage lenders, to whom many are in debt by virtue of owning homes. The operative word there is “slightly.” While the local bank won’t be sending you to jail, their recourse is essentially the next worst thing: repossessing your house. Once a mortgage lender determines that you cannot or will not repay your loan, it will exercise its contractual right to foreclose on your home and attempt to sell it, in order to recoup the money it lent you. The difficulties of losing your home are too obvious to require elaboration. And unfortunately, there is generally no less painful precursor to foreclosure. The bank will not garnish your wages, for instance, because the terms of your mortgage explicitly state that the property is the bank’s sole collateral for the amount of the loan. In other words, if you don’t pay up, expect to be foreclosed upon, or at least that it is a strong possibility. In fact, foreclosure may not even be the last of your troubles. If a bank cannot resell your home for enough money to recoup its costs, it can sue for what is known as a “deficiency judgment” against you in civil court. This judgment mandates that you repay the bank the difference between what it resold your property for and the outstanding balance of the mortgage.

If nothing else, make sure your taxes and mortgage gets paid. For all the attention that gets paid to credit card debt, it’s tough to top losing your freedom or the roof over your head.

Debt Priority #3 – Student Loans

While student loan repayments and interests have been on pause for the past few years, the student loan interest will resume starting on September 1, 2023, and payments will be due starting October 2023. 

Student loans begin taking us into the unsavory territory of wage garnishment. The Federal Student Aid site on collections states that if you fail to make arrangements to repay your debt the government can collect your debt by withholding money from your wages. As a federal entity, the Federal Family Educational Loan program can work with the U.S. Treasury Department to take away tax refunds to partially satisfy your unpaid student loans. You may be liable for collections costs if the government opts to turn your debt over to a private debt collector (more about them later.) Furthermore, you may be subject to Administrative Wage Garnishment, “…whereby the Department will require your employer to forward 15% of your disposable pay toward repayment of your loan.” In her book Debt-Free Living, personal finance author Mary Hunt writes that federal student loans are one of the rare kinds of debt that are generally not forgiven – even if you declare bankruptcy. While various student loan forgiveness programs are cropping up, the message should be clear: failure to pay student loans involves serious consequences, trailing only back taxes and mortgage debt in severity.

Debt Priority #4 – Credit Cards

Credit card debt, while certainly consequential, is the debt with the least immediate, direct consequences. Generally speaking, you would have to rack up an eye-popping amount of credit card debt (perhaps closer to six figures) before wage garnishments or liens come into the picture. Because credit cards involve private contracts between you and the card issuer, they are matters for a civil court to deal with. Therefore, no prison sentences can be imposed no matter how much you owe or how long you have owed it. Furthermore, credit card companies are not banks – that is, they have no interest in repossessing your plasma TV or anything else you bought on credit. They are after one thing and one thing only: repayment in hard cash. Failure to repay in this manner will not result in anything as dire as some of the penalties discussed earlier. What it will result in, however, is a damaged credit score. Depending on what you owe, how long you have owed it, and to how many creditors you owe it, you could find yourself paying a few extra points of interest on your next auto loan or, in the worst case scenario, completely unable to get any new credit whatsoever. Your unwillingness or inability to repay credit card debt could financially immobilize for much of your life or the rest of your life. So while it isn’t as urgent as taxes or mortgage payment, it’s hardly something to ignore.

Debt Priority #5 – Personal Contracts

Finally, the debt you ought to prioritize last are personal contracts, like those between you and a gym or health club. Believe it or not, these contracts often authorize the other party to pursue judgments against you and/or report negative entries on your credit history. Despite this, these creditors are often less aggressive than major credit card issuers in collecting outstanding debts. What typically happens is that the gym will exhaust its efforts to collect and, failing that, sell off your account to a collections agency who will then try to recoup their costs by collecting from you. Often times, these companies fail to collect as well. The likelihood of these people bringing you to court is even lower than that of credit card companies. Of course, do not forget that private collections agencies can report your delinquency to the credit bureaus and make it difficult for you to get credit in the future.

To recap, we have learned that the priority for debt repayment (when using consequences as the criteria) are:

1. Taxes
2. Mortgage
3. Student Loans
4. Credit Cards
5. Personal Contracts

Admittedly, other factors should be considered when deciding what to repay first. You can work out a flexible payment plan with the IRS, for instance. But when assessed strictly in terms of the consequences for not repaying, this is the order in which your debts should be repaid.