Everyone’s financial situation is different, so the money decision(s) you make must be based on your current financial condition as well as where you’d like to see your financial status in the future. Sure, there are many rules of thumb when it comes to investing, saving, debt payments and more, but when it comes down to it, any decision you make must be built around your actual financial situation, not what others think it should be or what you wish it was.
Once you’ve reviewed the numbers and have a better idea about your financial situation, you’ll be able to make better decisions. Of course, you have to start somewhere, so let’s begin with understanding debt.
The 2 primary types of debt:
- Primary Mortgage – loan used to purchase a home
- Home Equity Loan – single loan used against home equity
- Home Equity Line of Credit (HELOC) – renewable loan used against home equity
- Installment – borrowing a fixed amount of money for a large purchase
- Credit Card Loan – renewable borrowing for consumer expenses (gas, food, clothing, healthcare, etc.)
- Student Loan – loan used to pay for higher education expenses
Let’s Talk Interest
Consumer debt typically comes with a higher interest rate than mortgage-related debt. That means when you’re deciding whether to pay off debt or invest and save, it’s crucial to number crunch your interest amounts.
This is where an example comes in handy:
SAVINGS ACCOUNT: $10,000 earning 0% interest
CREDIT CARD DEBT: $10,000 charging 10% interest
NET WORTH: $0 ($10,000 of assets minus $10,000 debt equals $0)
ANNUAL LOSS: $1,000 (Each month your net worth shrinks because the interest on your debt is growing faster than the interest earned on your savings.)
In this instance, if you used the $10,000 in savings to pay the $10,000 in debt, your net worth would remain the same, but you would no longer be losing money. It’s the perfect scenario why paying off debt would be the best decision. However, always check and recheck your numbers to ascertain whether paying off your debt will save you – or cost you – money.
What about tax deductions?
Most mortgage-related debt not only has a lower interest rate, but also offers tax-deductions on that interest. So does that mean you should keep that debt so you can get tax deductions every April? Typically, no. You shouldn’t really concern yourself about losing a tax deduction by paying off your debt. Why? Primarily because the deduction is probably less than the yearly interest you would’ve paid on the loan.
Deciding to pay off a debt – or not – does not have to be “all or nothing”. It might be best for you (and your financial situation) to first pay off debts with high interest rates. This helps put more money in the coffers for you to invest in financial assets that earn a higher after-tax rate of return than the after-tax interest rate on any remaining debts you may have.
Keep in mind…
There are a few other items to consider when deciding if you should pay off your debt or invest/save money. Some of these include:
- If you pay off your debt, would you still have an emergency fund ? An emergency fund is crucial for unexpected financial issues. At least six to eight months of living expenses should be held for emergencies.
- Does your employer match your 401(k) contributions? If the answer is yes, invest at least the minimum required amount. You don’t want to give up this “free” money which could one day be worth a lot more than the interest you’re paying on your loans.
- Can you deal well emotionally with your current debt? If you’re comfortable with your current debt and are paying everything on time there might not be a reason to change the way you’re doing things.
- If you did pay your debt off, do you have money you could invest/save? Financially (and psychologically), it’s not a good thing if paying off your debt means you won’t have any money to save, invest, or enjoy life.
- Are there penalties for prepayment of your debt? Check the terms of your loan. You don’t want to end up paying more in penalties than the interest would have cost you.
Want to see if paying off any of your loans might be a good idea? Check out our Debt Payoff Tool that could help you make the best decision.