In 21st century America, the list of things that are more common than debt is depressingly small. From mortgages to student loans to credit cards, the types of debt and the terms of that debt run the gamut. Deciding how to address that debt– what to pay first, how to balance debt pay down and savings, how quickly to pay down debt – is a key part of financial planning. In this post, I’ll cover a few ways you can determine what debt you’d like to pay down first.
The most obvious thing to focus on in prioritizing debt to retire is the interest rate. However, when considering the interest rate, remember that in most instances, mortgage interest is tax deductible. So, if you’re paying 5% on your mortgage but your tax bracket (including both state and federal tax) adds up to roughly 30%, your interest rate after the tax deduction is 3.5%. In that instance, if the choice is between paying off your 4% student loans (and you don’t happen to qualify for a deduction on those) and your 5% mortgage, you’d choose student loans given the tax break on the mortgage interest.
Not all debt has interest rates that are fixed – adjustable rate mortgages and home equity loans typically have interest rates that are based on what’s known as a reference rate, and as the reference rate changes, your interest rate changes, too. These loans usually have a lower rate than fixed loans because the lender knows that if interest rates rise, they won’t be stuck with loans paying a below-market interest rate. For a borrower, the lower interest rate and payment can make it easy to overlook the risk of rising rates.
If only a small percentage of your debt has a rate that floats, you’re probably fine. But if you purchased a home in, for example, Decatur and you have total debt of $600,000 spread between an adjustable rate mortgage and a home equity loan, rising rates could quickly lead to trouble. A 1% increase in rates would lead to an additional $6,000 year in interest payments, and if that would be a stretch for you, you might consider focusing on paying down or refinancing some of the floating rate debt you have.
One last approach to paying down debt is what I’ll call the momentum based approach. Dave Ramsey touts this approach in his programs, and the basic idea is that you begin by paying off the smallest debt first – regardless of the interest rate. Once the debt is paid off, you’ll have improved cash flow and you can move on to the next debt. Equally important, you’ll feel a sense of accomplishment at having paid down some debt, and this will give you momentum in tackling the rest of your debt moving forward. As someone who just recently paid off a car loan with an interest rate somewhere south of 2%, I can attest to the advantages of this approach.
None of us have unlimited cash flow, so once you’ve prioritized your debt the next step in financial planning is to determine how to strike a balance between paying down debt and savings. I’ll cover some rules of thumb for that in next week’s post.
Micah Porter is a financial advisor located in Atlanta (Decatur). For more information please contact us.