Deciding whether to pay off debt early
One of the great conundrums we face in our financial lives is what to do about debt. Some people think debt is bad, and we should get rid of it as soon as possible. But we also must build up savings for emergencies, retirement, a home down payment and college for our children. We often need to balance paying down debt with building up savings for the future.
One way to decide what to do is to compare the interest rate you are paying on your debt to the investment returns you are earning on your savings. From a purely financial standpoint it often makes sense to pay down high-interest debt that costs more than you are earning on your investments. And if you're paying less interest on your debt than your savings is earning, debt can be a good deal. But there are also emotional considerations, including how having debt makes you feel.
Financial aspects. The first thing you should look at when considering whether to pay off debt is the financial effects of holding debt versus paying it down. This is extremely variable, depending on the type of debt that you have and the cost of the debt relative to the payoff of saving.
In order to gauge the financial effect of holding debt, you need to quantify what you have. For example, let's say your debts include an $80,000 mortgage charging 3.5 percent interest, a $20,000 car loan charging 7 percent interest, $2,000 on a credit card with a 15 percent interest rate and $500 on a department store credit card charging 18 percent interest. On the savings side, you have $10,000 in college savings accruing 6 percent interest, $100,000 in a retirement account also earning 6 percent annually and $10,000 in an emergency fund paying a paltry 0.1 percent. Assuming that you have all the monthly minimum obligations for debt covered, are making some contributions to your retirement and college savings and have a little money left over, you need to prioritize whether to make extra debt payments or do additional saving.
Tantamount to your financial success is making certain that you have an emergency fund available. In today's world, layoffs occur regularly and unexpectedly, and you need funds to help you get by if this should happen. Other sudden expenses, such as new tires for the car or replacing your furnace, can be quite expensive and often need to be completed on short notice. These necessary items should be taken care of with your emergency fund. An emergency fund equal to six months of your essential household expenses is ideal, which in this case would be around $25,000. So the first priority for extra payments should be toward your emergency fund.
Once you have a fully stocked emergency fund, you need to compare the cost of the debt versus the rate of return on your savings and pay your extra dollars toward the items that will have the biggest financial impact. Since your credit cards are charging much more in interest than you are earning on your investments, your next priority should be to pay off the $500 department store credit card charging 18 percent interest and then the $2,000 credit card balance that is costing you 15 percent in interest. It's better to pay extra toward the department store charge account before paying off the regular credit card because the balance on the store card is costing you more than the charges on the regular credit card. By paying extra toward the higher rate you're getting a guaranteed return of that higher rate. After that, the car loan charging 7 percent interest is costing you slightly more than you are earning on your retirement and college savings.
In the case of the mortgage, the 3.5 percent interest rate costs much less than all the other types of debt, so it makes sense financially to save extra payments on your mortgage for last. If you pay extra toward your mortgage balance, rather than your credit cards, you are forgoing the better return you would get from putting extra money toward higher interest debt. In today's low mortgage rate environment, it make sense to save the mortgage payoff for last or even stretch out the time you are paying the mortgage back in order to receive the higher payoff of eliminating credit card debt or even saving for retirement.
Emotional aspects. Emotions drive many of our life decisions, including financial ones. When looking at your balance sheet, you may have emotional priorities that will drive some of your financial choices.
For example, you might decide that you just can't stomach the concept of having any debt at all. If that's the case, you need to keep in mind that your savings and investments for the future will suffer as a result. But if this is what allows you to sleep better at night, then you might prioritize paying extra for your mortgage over saving more for college and retirement.
But before you do that, realize that the choice doesn't have to be debt or saving. Perhaps you have a total of $300 extra at the end of the month, after paying the minimum on your mortgage and contributing to your college and retirement savings accounts. While your top priorities should be getting your emergency fund balance up to where you need it to be and paying off consumer debt on charge cards and high interest auto loans, after that you could split the extra $300 between your remaining goals. Instead of devoting it all to the mortgage, you could put $200 toward the mortgage and $50 each toward your retirement and college savings.
Jim Blankenship is a certified financial planner who blogs at Getting Your Financial Ducks in a Row.
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