Debt can feel scary. Between the seemingly endless payments, the possibility of bankruptcy, the potential for negative net worth, and the general unease of owing money; it’s just not fun.
But should you pay off your debts early? If so, which loan should you pay off first? Or should you set aside savings instead?
These are some of the most pressing questions on the minds of our younger clients because—let’s face it—those early in their careers often have a larger portfolio of debt than of investments. However, like most financial questions, there is no one answer that’s right for everyone.
Here are our top 9 questions to consider when deciding whether to pay off debt.
1) Do you have a workplace retirement plan with an employer match?
If your employer provides a match for your contributions to a retirement plan, that’s free money. Remember, if you have a retirement plan with a match of 2% of your salary and you aren’t contributing to get that match, you are essentially turning down a 2% raise.
Even without a match, retirement contributions may be more advantageous than the guaranteed return (see below)of debt repayment.
2) How much cash savings do you have?
We often hear that people far from retirement should invest aggressively since they have time to recover from market downturns. However, this does not account for short-term and emergency savings. We believe that people in their 20s and 30s often need 50%-75% of their overall portfolio in interest earning investments (like savings accounts, bonds, and CDs). This is because their emergency fund and short-term savings (for expenses like a wedding or a down payment for a home) make up a large proportion of their total savings.
3) What interest rate are you paying?
This is an important factor in deciding which debt to pay off first since this has the largest impact on the total amount of interest you will pay over time. For example, let’s assume that you have two credit cards each with the same balance. One has an interest rate of 10%, while the other charges 20%. If you make the same monthly payments to each, then you will pay more than twice as much in interest on the 20% card.
By paying off a loan, you are reducing the amount of interest you pay. In a way the extra money you pay each month could be considered an investment that guarantees a return equal to your interest rate. The logic behind this can seem a bit confusing, but extra debt payments can be considered savings so long as, once the debt is paid, you pay yourself (save) the amount you had been paying the lender.
4) What is your attitude about debt?
Financial well-being is not just about money; it’s also about your ability to sleep at night. If the thought of your low-interest car loan feels like a punch in the gut, you may want to pay it off, even if it does not make much of a difference financially.
5) What return do you expect on your investments?
Based on actual historical data, what return can you reasonably expect for your investments? How does this compare with the guaranteed return you can receive from debt payments?
6) Will you really save the money?
The idea that paying off debt gives you a guaranteed return is great in theory, but if you just spend the money (or build up more debt), then you have no return at all. If you are thinking about paying off debt early instead of contributing to a retirement account, ask yourself what you will actually do with the extra money once you have paid off the debt. How much will actually go into your long-term savings (or be used to pay off other debts)?
7) What are the tax consequences?
Interest paid on some kinds of debt can be deducted from taxable income. As many people know, mortgage interest can often be listed as an itemized deduction.
A lesser-known interest deduction is the one for interest paid on student loans. This deduction is above the line, meaning that it can be taken without itemizing, will lower the minimum threshold for some itemized deductions, and may help qualify some for tax credits. While the Student Loan Interest Deduction can be very beneficial, the most someone can deduct is $2,500 (and it’s phased-out at higher incomes).
Most other interest is not deductible.
8) Do you think you will qualify for student loan deferment at some point?
Payments on student loans can sometimes be deferred, reduced, or canceled. For example, some student loans do not have to be repaid while you are enrolled in school at least half-time (although interest may or may not accumulate during this period). Economic hardship, active duty in the military, death, and other circumstances can also change student loan repayment obligations. These possibilities may prompt you to pay off other debts first.
9) Can the debt be discharged in bankruptcy?
We hope you will not have to deal with this, but sometimes bankruptcy is the best solution. If your debt is so severe that it’s a major concern you should contact a not-for-profit credit counseling service such as Apprisen (www.apprisen.com).
Whether or not you are considering bankruptcy, keep in mind that student loans often cannot be discharged.
It’s also worth noting that creditors do not have access to most retirement plans. So it is rarely advisable to take early distributions from accounts such as 401(k)s and 403(b)s to pay off debt.
As we noted, selecting a debt repayment strategy can be a difficult decision that involves both facts and emotions. What’s more, there may be more than one right answer for you, so don’t agonize over your conclusions too much. These questions can help you make an informed decision so you can you feel as comfortable as possible as you take your next steps.
Copyright © 2015-17 by Practical Financial Planning, Inc.