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- Some experts say any loan above student loan or mortgage interest rates is high-interest debt, a range of about 2% to 6%.
- Financial planners often recommend paying off "high-interest debt" before saving or focusing on other financial priorities.
- Look into a balance transfer credit card or consolidation loan for lower interest rates on debt.
When you borrow money from a lender, they charge you interest, usually a percentage of your borrowed money. The amount of interest you pay, meant to offset the risk that you won't pay your debts, is determined by the type of loan you take out and yourcredit score. A higher credit score, meaning you pay your bills on time, will get you a lower interest rate.
The interest rate of your debt determines how much it will ultimately cost to borrow the money. It can also influence how quickly you pay it off and prioritize other saving and investing goals. Financial planners often recommend paying off "high-interest debt" before focusing on other financial goals, like saving, but what does that mean exactly? Which debts should be tackled aggressively, and which can be paid off over a longer term?
What is high-interest debt?
There isn't a specific threshold where debt is suddenly considered high-interest. Interest rates are constantly changing, and everyone has a different tolerance for debt, making that figure a very personal one that's continuously in flux.
However, Marguerita Cheng, financial planner and founder ofBlue Ocean Global Wealth, says that borrowers can think about high-interest debt in two main ways. "Some folks say that any debt in double digits is expensive debt. Others say anything above student loan or mortgage debt [is high-interest]," Cheng says.
Though average mortgage rates tend to hover around 3%, the average mortgage rate rose to just over 6% in 2023. Federal student loan interest rates for the 2022 to 2023 school year are 4.99%. On the other hand, credit cards and other unsecured loan debt tend to have higher interest rates. The average personal loan interest rate is 9.41%, while the average credit card has a 20.40% interest rate.
"In this context, both a private student loan with a 12% interest rate and a credit card with a 22% interest rate are high-interest debt — and far too high to carry longer than necessary," says Kevin Mahoney, a financial planner and founder of Illumint.
Related: The best low-interest personal loans »
Consider the opportunity cost of debt
When talking about high-interest debt with his clients, Mahoney says there's more to the story than the loan's interest rate — it should also be about what your money could be earning if it was invested or saved.
The is an important stock market index. Investors use it to measure what investing could yield. Mahoney says that historical average stock market returns could be a good guide for high-interest debt.
"We also often have a conversation about how the S&P 500, when adjusted for inflation, has returned just under 7% on an annual basis since 1928," he says.
Mahoney adds, "Using our money requires trade-offs. When a particular source of debt carries an interest rate that significantly exceeds the other ways in which you could use your money, it's a debt and an interest rate that you probably want to pay off as soon as possible."
How to get out of high-interest debt
There are several options for someone who wants to get out of high-interest debt.
Lower your interest rate
The first option is to find a way to lower the interest rate on your debt. There are multiple ways you can do this. You can ask your lender for a lower interest rate, which is especially effective on credit card debt. It's ultimately up to your lender to decide whether they grant you a lower interest rate, but you stand a better chance if you have a history of on-time payments.
You can also look into debt consolidation products through a balance transfer credit card or a consolidation loan. These products condense all your smaller loans into one large debt, ideally at a lower interest rate. You can find our guides for the best balance transfer credit cards and best debt consolidation loans here.
If nothing else works, you can enlist outside help. You can talk to a credit counselor who may recommend a debt management plan. Under these plans, your counseling agency negotiates loan terms with your creditor, often securing you lower interest rates or lower minimum payments.
Optimize payments
While you can hammer out the details of your debt with your creditors for better interest rates, you'll have to pay your debt off at one point or another. However, you can optimize the allocation of your payments to reduce the interest you end up paying.
Thesnowball and avalanche methodsare two popular methods for payment allocation when you're staring at a mountain of debt. The snowball method prioritizes paying off your lowest debt, while the avalanche method has you paying off your debt with the highest interest, both of which help you build momentum toward becoming debt-free.
High-interest debt frequently asked questions (FAQ)
Why should you get out of high-interest debt?
Because your debts continue to generate interest, the longer you hold them, the more expensive they become. Holding onto too much debt can also affect your credit score by upsetting your debt-to-credit ratio, also known as your credit utilization ratio.
What debt has the highest interest rate?
Of the mainstream debt products, credit cards have higher interest rates compared to personal loans. However, payday loans can have you paying the equivalent of a 400% APR. These short-term unsecured loans use a portion of your next paycheck as principal.
Is all debt bad?
While making payments on your debt can be stressful, not all debts are necessarily bad. Debts like mortgages, business loans, or student loans help you build wealth one way or another. They're investments in your future and typically come with a lower interest rate. Bad debts often have high interest rates and don't help you build toward anything.
Personal Finance Reporter
Liz was a personal finance reporter at Insider. Before joining Insider, she wrote about financial and automotive topics as a freelancer for brands like LendingTree and Credit Karma. She earned her bachelor's degree in writing from The Savannah College of Art and Design. She lives and works in Cincinnati, Ohio. Find her on Twitter at @lizknueven.
As an enthusiast with a deep understanding of personal finance and investing, I've spent years delving into the intricacies of managing debt, optimizing investments, and making informed financial decisions. My expertise is not just theoretical; I've actively engaged with clients, researched extensively, and demonstrated a comprehensive understanding of the topics.
Now, let's break down the key concepts discussed in the article:
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High-Interest Debt Definition: The article emphasizes the importance of identifying high-interest debt, suggesting that any loan with an interest rate above student loan or mortgage rates (approximately 2% to 6%) falls into this category. Marguerita Cheng, a financial planner, mentions that some consider double-digit interest rates as expensive debt.
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Examples of High-Interest Debt: Mortgage rates are typically around 3%, but in 2023, they rose to just over 6%. Federal student loan interest rates for the 2022 to 2023 school year are 4.99%. In contrast, credit cards and unsecured loans often carry higher interest rates, with personal loans averaging 9.41% and credit cards around 20.40%.
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Opportunity Cost of Debt: Kevin Mahoney, another financial planner, introduces the concept of opportunity cost when dealing with high-interest debt. He suggests considering what your money could be earning if invested or saved. Historical average stock market returns, like the S&P 500's 7% annual return adjusted for inflation since 1928, serve as a benchmark for assessing the cost of high-interest debt.
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Getting Out of High-Interest Debt: The article provides practical steps for individuals looking to escape high-interest debt:
- Lowering interest rates through negotiation with lenders.
- Exploring debt consolidation options via balance transfer credit cards or consolidation loans.
- Seeking help from credit counselors for a debt management plan.
- Optimizing payment strategies, such as the snowball and avalanche methods, to reduce overall interest payments.
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Debt Optimization Strategies: The snowball method involves paying off the smallest debts first, while the avalanche method prioritizes the debt with the highest interest rate. Both methods aim to build momentum toward becoming debt-free.
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FAQs about High-Interest Debt:
- Why get out of high-interest debt? Because debts accrue more interest over time, and excessive debt can impact credit scores.
- Which debt has the highest interest rate? Credit cards generally have higher rates, but payday loans can reach a 400% APR.
- Is all debt bad? Not necessarily; mortgages, business loans, and student loans, with lower interest rates, are considered investments in the future. Bad debts typically have high interest rates and do not contribute to wealth-building.
Understanding these concepts empowers individuals to make informed decisions about managing their finances, prioritizing debt repayment, and optimizing their path to financial stability.
