There are many different theories out there about paying off debt. Some believe in putting every penny you can into paying off your debt, and paying it off as soon as possible. Others believe in paying down your lowest balance debts first (even if they have a low interest rate), then working your way up to larger debts (this is referred to as the snowball method). Perhaps the most financially optimal method of paying off debt is paying off your debts with the highest interest rate first, then moving on towards lower interest debts.
There are four main types of consumer debt in the United States: credit cards, student loans, auto loans, and mortgages. They should each be treated a little differently; credit cards usually have the highest interest rate so I’ll start with them.
(Note: this article discusses different options for refinancing debt and debt prioritization. If you’re struggling with creating extra money in your budget to afford your debt payments, check out my article on budgeting.)
Credit cards are unsecured debt, meaning the credit card companies have no physical assets to come take if you don’t pay your bills (this doesn’t mean they can’t take you to court). If you don’t pay your credit card bill, nobody is going to come to your house and take your big-screen TV and new Xbox. Since credit card debt has no physical collateral, the interest rate is higher than other debts like a mortgage where they can take your house, an auto loan where they can take your car, or student loans that are backed by the government.
If you have credit card debt that is going to take more than a few months to pay off, there are a few different options you may have to lower your interest rate. The first one - and the easiest - is to call your credit card company and ask them to lower your interest rate. You may want to mention how long you’ve been a customer, or how you received an offer to transfer your debt to another company at a lower interest rate. Credit card companies want to keep collecting interest from you, even if it’s at a lower rate, so they may offer to lower your interest rate.
Balance transfer cards are another option to lower your interest rate. When you open a balance transfer card, you can transfer existing credit card debts to the balance transfer card and pay 0% interest for around 12-24 months, depending on the card issuer. One thing you need to look out for is balance transfer fees; cards may charge a flat fee of around 3% to transfer your balance. There are some cards out there that may offer fee-free balance transfers within the first XX days of opening your account.
There are other options to consolidate your credit card debt, such as personal loans. Anything that has a lower interest rate and allows you to save money in the long run is a good option, but when investigating different sources for refinancing credit card debt beware of hidden fees.
Student loans are a strange type of debt. There is no collateral for the student loan company to take if you don’t pay; fortunately they won’t send someone to take away your degree if you can’t afford your student loan payments. Many student loans have very low interest rates for unsecured debt, though. This is because federal student loans are backed by the government, and student loan debt is almost impossible to discharge in bankruptcy. Right now the only realistic options for getting rid of student loan debt are paying it off or dying. And even if you do die, student loan servicers may still come after your family and try to collect on a debt that your family is not legally obligated to pay. This is an industry which has been widely discussed in politics lately and desperately needs reform (the secretary of the Department of Education is a student loan shark though, so we will probably have to wait for a new administration to see any progress).
If you have student loans, you need to know all of your interest rates. Private student loans typically have higher interest rates than federal loans. If you have private student loans with high interest rates, consolidating your student loans may be a good idea. If you have excellent credit, you may be able to get a fixed interest rate as low as around 4%. You may have federal student loans with somewhat high interest rates, but it’s important to note that if you refinance federal student loans you are no longer eligible for any special payment plans such as Pay As You Earn or Income-Based Repayment.
Auto loan debt won’t usually kill you on the interest rate (although it can if you have bad credit), but it will kill you on the term length of the loan. The length of auto loan terms are getting pushed further and further out to make cars cheaper per month. It would probably be a good idea to have the ability to payoff your car loan within 3 years of purchasing your vehicle; if you can only afford a car if you spread out the payments across 8 years, you can’t really afford it. What will happen if your car completely breaks down after 5 years and is worthless? You now owe $10,000 on an asset that is worth nothing, and you have to take out another loan for another car and start the cycle again.
I have only ever purchased used cars so I can’t really comment on the satisfaction of being the first or only owner of a car, but I do know that used cars are much, much cheaper than new cars and you can still get great, reliable cars for a fraction of the price of new cars. If you’re at the same stage of life I am, where you want a car to get you from point A to point B and don’t need anything luxurious, I would suggest looking into reliable cars like Toyotas or Hondas. They might be boring, but they are very low maintenance and will get you where you need to go.
New cars are a luxury good, and there is nothing wrong with buying a new car if you can afford it. I have friends that have bought new cars when they couldn’t afford it though, and it can be detrimental to your long-term financial health.
Mortgage rates are pretty low right now, so refinancing may be a good option if you can lower your interest rate. Interest rates for mortgages are usually pretty low, but that’s because the bank can take away your house if you can’t make the payments. 30-year mortgages are the most common right now; there’s nothing necessarily wrong with such a long term, but you need to make sure the monthly payment doesn’t eat up too much of your income (25% of your monthly income is a good rule of thumb). It’s also a good idea to only buy a house in an area where you’re pretty sure you’ll be around for at least 5 years. If you have to sell a house soon after purchasing it, you could end up underwater (owing more than the house is worth) very easily.
When it comes to putting money down, 20% is the standard. You’ll start right off the bat owning 20% of the house, which means it would be harder for you to go underwater on the house. If you don’t put 20% down, you’ll probably have to purchase private mortgage insurance (PMI) as well.
What debt should I pay off first?
The most financially optimal way to pay off your debt is to prioritize it in order from highest interest to lowest interest. It can also be argued that it’s financially optimal to pay the minimums on debt like student loans if the interest rate is significantly lower than what you can expect to earn in the market. For example, if you have student loans at 4% interest, it might be better to put your extra money into a retirement account rather than towards your student loans.
Stock market return is not guaranteed though, while paying off debt early offers you a guaranteed return on your money. Ultimately, you need to do what makes the best sense for you. Prioritizing saving for retirement over paying down debt may make the most financial sense, but your risk tolerance and emotional attitude towards debt must also be taken into account.
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