Written by: Corey Janoff
This post was originally published on our previous blog website on August 15, 2018 and has since not been revised and/or updated.
In a perfect world, everyone is debt free. The world isn’t perfect, though. We need to make do with our debts and figure out the most efficient way to pay them off, while still reaching our other financial goals. Today we will look at good debts versus bad debts, the most efficient ways to pay off debts, and some general rules of thumb.
Not All Debts Are Bad
If you can, avoid debt. However, sometimes debt can help advance you towards your goals in an effective manner. For example, if you have an advanced degree in medicine, law, or dentistry, there is a good chance you had to take out student loans to pay your way through school. Well, if student loan debt didn’t exist, you wouldn’t have been able to pursue that career, unless you were fortunate enough to get scholarships or have parents pay for it.
Some people take out more student loans than they need and end up racking up a lot of unnecessary interest, which can cause an additional burden. But if managed appropriately, loans for education are an investment in yourself and your future success. Investing in yourself is the best investment you can make!
Also, some of you may want to own a home one day. Unless you have a lot of cash lying around, it will be difficult to buy a house without a mortgage. Many of you are already homeowners with a mortgage balance. Without the ability to get a mortgage, you wouldn’t be a homeowner. On top of that, the mortgage interest is tax-deductible up to a certain extent. A mortgage can help you reach a goal of homeownership sooner than you would be able to without a mortgage. Assuming you don’t overextend yourself, this helps accelerate the path to a financial goal in a positive way.
Finally, I would consider a business loan a good form of debt. If you want to start a business, or buy into a business one day, you may need to take out a business loan. If it is well thought out and well planned, this can be a great investment. Again, you are investing in yourself and your future success, which is the best investment you can make.
Most Debts Are Bad
Now that we got the good debts out of the way, let’s talk about bad debts. Student loans, mortgages, and business loans can fall into the “good debt” category. Pretty much everything else falls into the “bad debt” category. Some are less bad than others, but unless you have a good reason for taking out the debt and the interest is low, be prepared to explain yourself.
There is no reason to carry a balance on a credit card. If your balance carries over to the next billing cycle and accrues interest, you are spending too much. Stop it.
If you take out a personal loan to do some home renovations, you are just digging a hole for yourself. Don’t do it.
The 0% interest rate furniture loans make sense on paper, but if you can’t afford to pay $3,000 cash for a leather couch, you probably shouldn’t buy the couch.
I could go on, but you get the idea. Stop spending money you don’t have on stuff you don’t need.
Focus on the Interest Rate
An easy way to start organizing your debts and prioritize how to pay them off is by the interest rate. Forget about the balance, forget about the type of debt, and focus on the interest rate. The higher the interest rate, the worse the debt. Your highest interest rate debt is accruing interest faster than all of your other debts. So the sooner you can pay it off, the less it can hurt you.
Mathematically, the quickest way to become debt free is to pay the minimum amount due each month on all of your debts, except the one with the highest interest rate. That single highest interest rate debt is the one you want to pay extra money towards. Once that one is paid off, turn your attention to the next highest interest rate debt. Work your way down the ladder one by one from highest interest rate to lowest interest rate.
Let me show you why this is. Let’s say you have two debts, a car loan and a credit card. The car loan has a 3% interest rate and the credit card has an 18% interest rate. If you have an extra $100 that you can use to pay off your debts, which debt should you make the extra payment to?
Well, if you pay $100 off of the car loan, that is $100 of debt that will no longer accrue interest moving forward. At a 3% annualized interest rate, paying off $100 will save you $3 per year in interest.
If you put the $100 towards the credit card, that is $100 that won’t accrue interest at 18%, which will save you $18/year in interest moving forward. Saving $18 is better than saving $3, so it makes sense to pay extra on the credit card before paying extra on the car loan. Pretty straightforward.
This is often referred to a debt snowball strategy. Once one debt is paid off, you take that minimum monthly payment plus the extra payments you were making and direct those towards the next debt. The snowball of extra payments continues to grow in size as each debt gets eliminated.
Another popular strategy is to pay off debts starting with the smallest balance first and work your way up the ladder from smallest to largest balance. Mathematically speaking, this is not as optimal as highest interest rate to lowest interest rate. However, this can be emotionally satisfying. Psychologically it feels damn good to pay off a debt. So if you can get some extra motivation to eliminate all your debts by paying off a small debt, even if it has the smallest interest rate, then go for it! You might set aside some extra money to pay off debt with that you wouldn’t have set aside if you were using the interest rate strategy. If that is the case, then more power to you. If it keeps the momentum going, then I can support it.
What Interest Rate is Considered Too High?
I like to draw a line in the sand around 7% interest. If you have debts with interest rates above 7%, in most cases I would like to see those paid off aggressively before addressing other financial goals. Why is that?
Well, by paying off a debt, you are essentially getting a guaranteed rate of return on your money. If we use the credit card from the previous example at 18% interest, by paying that off, you are guaranteeing yourself an 18% rate of return on your money. This is because by paying it off, you are avoiding the interest expense that you would have to pay if you let the interest accrue. In order to justify holding onto an 18% interest rate debt, you would need to invest your money and realize a rate of return that is greater than 18% per year. There isn’t an investment out there that can guarantee you an 18% rate of return, so your best bet is to pay off the credit card.
Lower interest rate debts are more of a case by case basis. Yes, we want to pay off all of our debts, but we also have other goals we want to achieve. If you delay retirement savings until you are completely debt free, you may not be able to retire until you are in your 80’s! So if you have a car loan at 1.9% interest, I would make sure all of your other financial goals are on track before making extra payments on the car loan. 1.9% is less than inflation historically. The bank is essentially losing money on you by only charging 1.9% interest.
Odds are, your car loan is on a 5-6 year payment schedule. So whether you like it or not, if you pay the minimum payment each month, the car will be paid off within 5-6 years. I can live with that. I would rather see you save enough so you can retire within your desired timeframe before making extra payments on the car loan in this example.
There You Have It
Avoid debt if you can. If you have debts, go after the highest interest rate first. I can live with low interest rate debts if you are putting your extra money towards achieving your other financial goals. Also, not all debts are bad. If you are borrowing money so you can advance your career or business goals and it is well thought out and well planned, I can support it.
Hopefully this aids you in your approach to eliminating your debt.
