Debt Management 101: The Good, the Bad, and the Ugly
If you're among the 69% of American households that carry some type of debt, hopefully you're taking steps to manage and pay it down responsibly.
However, when it comes to debt management, not all debts are created equal. If you're in the fortunate position to have some extra cash to put toward paying down your debts, prioritizing your debts can be the most important factor toward your long-term financial health.
Even though it might sound good to pay down more on your house or your car, you might be able to put your money to better use.
Good debts: Leave them alone, even if your other debts are paid
When I say "good debts," I mainly mean mortgages; but it can also refer to any low-interest debt, such as if you have a car loan at 1.9% APR.
Basically, if your interest rate is that low, you'd be better off taking your extra cash and investing it rather than using it to pay down that debt faster. In other words, if you owe $100,000 on your house at 4.25% interest, you're paying interest at the rate of $4,250 per year.
However, if you can invest that and earn, say 7% returns, you'll make $7,000 in a year, or $2,750 more than the interest on your debt. And, if you don't think a 7% annual return is achievable, consider that the S&P 500 has averaged total returns of 9.6% per year for the past two decades.
OK debts: Your second priority
This refers to car loans, student loans, and other consumer loans like these. An "OK debt" has a relatively low interest rate -- 7% or less is a good guideline -- and is used to buy something that has a positive and justifiable impact on your life.
For instance, a car helps you get to work. A student loan helps you get a degree, which increases your earnings power. These are debts that are OK to carry, as the interest you pay and the returns you can earn from investing the money are probably pretty close.
If you want to make an extra dent in these debts, go ahead, but only after your bad debts are taken care of.
Credit cards and other bad debts
Don't even consider paying extra on your house, car, or student loans if you have any outstanding credit card debt or other high-interest debt. And don't invest your extra cash, either.
To show you why, let's consider an example. Let's say that when you do your taxes this year, you end up with a $3,000 refund, which you decide to put toward your debts. And your two biggest debts are a $12,000 48-month auto loan at 6% interest, and a $5,000 credit card balance at 18% interest.
Paying down $3,000 of the auto loan will save you about $380 in interest over the life of the loan. However, paying down $3,000 of the credit card debt will save you $540 in interest in just one year.
When it comes to investments, putting $5,000 into a brokerage account while paying 18% interest on $5,000 of credit card debt is just silly. Even if you turn out to be an excellent investor, and can deliver consistent 12% annual returns, you'll still lose money in the long run.
Every little bit helps
Don't underestimate the impact of paying just a little bit extra on your credit cards each month. If you owe $5,000, and your minimum payment is 2% of the outstanding balance (or $100 to start), you could spend more than 35 years paying off the balance. If, however, you increased your payments by 50%, starting with $150 per month, you would cut your repayment time in half to less than 17 years.
Don't think that you can't make an impact just because you only have a few extra bucks to pay toward your debts. Every little bit helps, and paying off the right debts first helps even more.
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