Written by: Jeff Pratt
This week's blog post originally appeared on our previous blog website, financialclarityblog.com on January 31st, 2017.
If you are lucky enough to be debt free, I would still encourage you to read this post as I’m sure you know someone with a debt load weighing over their head. It could be credit cards, hospital bills, student loans, mortgages, and/ or auto loans to name a few.
Whatever the situation may be it takes hard work and dedication to reduce any debt burden. However, when sitting down and looking at everything it can also become overwhelming; putting you in a position where you feel like you don’t even know where to start.
Well hopefully I can help. Below are some helpful tips to eliminating debt as efficiently as possible.
Prioritize by Interest Rate
From a financial standpoint you want to rank all of your liabilities by interest rate – focusing your efforts on paying down the highest interest rate obligation first and working your way down to paying off the lowest interest rate obligation. You can do a Google search and come across dozens of debt reduction strategies, but from a mathematical standpoint, focusing on interest rates will help ensure you minimize the interest paid over the life of different obligations.
What this typically means is first getting rid of the consumer debts like credit card balances since they tend to carry the highest of interest rates. After those are taken care of you might move on to student loans, auto loans after that, and eventually maybe a mortgage.
Opportunity Cost – What Else Could I Do with the Money?
In general you want to think about opportunity cost when it comes to paying down debts. Meaning you have to consider the trade-offs of taking route A and giving up the opportunity to take route B. For example, going to college for four (or more) years means giving up the opportunity to work in another occupation and generate income during those years.
To put this concept into numbers, let’s say you have $1,000 left over at the end of the month and you want to pay off one of your debt obligations. Let’s also assume in this example one of your obligations is a credit card at 20% interest and another obligation is an auto loan at 3% interest. Both have $1,000 remaining on them.
- For the credit card at 20%, if the balance sits there for a year and you let the 20% interest accrue, you are now looking at a balance of $1,200. On the flip side, if you pay the card balance off with the extra $1,000 you have, you would be eliminating that $200 of interest accrual. In a sense, you are guaranteeing yourself a 20% rate of return on your money by avoiding the interest (not too shabby!).
- For the auto loan at 3%, paying that balance down with the $1,000 essentially means you don’t think your extra $1,000 can work more productively elsewhere. This is not true because you can make that $1,000 work harder by putting it towards the 20% credit card balance (and thus keep only the minimum payment flowing towards the auto loan).
Should I Invest or Pay off Debt?
Expanding beyond debts, let’s take a look at the example 3% auto loan and compare it to potentially allocating the $1,000 left over at the end of the month to an investment account. Now there are several ways to structure investment accounts, but for the purposes of this example we’ll say all we are trying to do is mirror the historical returns of the S&P 500 (which, according to this database has been about 9.5% per year).
Keep in mind the 9.5% mark is only an average and history doesn’t provide any indication of future returns. Also, there is risk taken on to generate that investment return so it may not be appropriate for everyone to invest in the market. Lastly, you cannot invest directly in an index, but there are plenty of mutual funds and ETF’s that try to mirror an index at a very low cost. That being said, I think this hypothetical example paints the opportunity cost picture well as there’s an opportunity to potentially invest $1,000 and have it grow at a faster rate than reducing your 3% auto loan.
But I Just Can’t Stand Having Debt!
Now up until this point we’ve only focused on the mathematics. Since I know not everyone thinks in that manner what I will acknowledge now is the emotions that come with debt burdens. I’m pretty sure most people can understand the level of satisfaction felt by paying off debt. This often leads to situations where it could make sense to pay off a lower interest rate debt first. Yes, it would be less efficient as it would result in more interest being paid, but if you sleep a thousand times better knowing the debt is out of your life, it could very well be worth it.
Bringing It All Together
Speaking to the point above, although an uncomfortable feeling, it may not make sense to solely focus your efforts on getting rid of your debts. Depending on the situation and your goals it very well could be a balancing act between paying down debts, saving for retirement, building up emergency reserves, and/or saving for a home down payment as an example.
At the end of the day, it’s important to understand there are a multitude of factors that go into deciding how best to address your specific debts, but hopefully after reading this post you have a little better sense on where to focus your efforts.
This for informational purposes only, and should not be construed or acted upon as individualized investment advice. Any examples are hypothetical and for illustrative purposes only. The rates of return do not represent any actual investment and cannot be guaranteed. Any investment involves potential loss of principal.