Watch enough westerns and adventure movies and you’ll notice a theme amongst the heroes and heroines who come out on top in a bar-room brawl: take out the biggest guy first and work your way down from there. Taking the attack to the most dangerous enemy while you’re still fresh keeps you from getting beat up later on. Your approach to attacking your debt should be the same: prioritize and then eliminate.
How to decide which debt to attack first
- Knock out your highest interest debt first, especially high interest credit card debt or any other high interest loans.
- Next attack the non-tax deductible debts, such as bank loans, car loans or any other debt that doesn’t allow you to write off the interest on your taxes.
- Third, beat up the debt with tax write-offs like student loans.
- Lastly, blitz your mortgage. Nothing gives peace of mind like a paid-for home.
Shouldn’t I be using this cash for investments?
Let’s consider an example to illustrate why you should use extra cash to pay off debt instead:
You have $5,000 sitting in your savings account. Unfortunately, like the majority of other Americans, you owe $10,000 on a credit card. What are your options with that cash?
You can invest it in an index fund or a bond and receive a 6-12% rate of return on it at year’s end. You’re up $300 to $600! But …
Your credit card debt (assuming 16.9% interest in an industry that can charge as much as 28%) costs you $200 that month alone! If you don’t pay it down, it will cost you the same next month as well. That’s $2,400 in after tax payments. If you’re paying approximately
Should I use ALL my savings to pay off debt?
No, not necessarily since your situation may differ from mine or anyone else’s. What IS important is that you get this high interest debt paid off as soon as possible. It’s always good to have a bit of a cushion, a couple month’s living expenses in an emergency fund, but any money in excess of that should be used to obliterate your high interest and non-tax advantaged debt as quickly as possible.
Put another way, your investments won’t outpace the loss you are taking on any credit card debt. If you use the $5,000 to pay down your credit card, you’ll only pay $100 the next month. If you invested it in the index fund or bond fund mentioned earlier, you’ll only earn $25-$50.
Debt puts undue pressure on your investments. If you have a debt with an 12% interest rate, you have to get a tax free investment that returns more than 12% to make carrying the debt worthwhile. Millions of people have trouble finding an investment that returns even 8% consistently. The high interest and non-tax deductible debts are significant obstacles to profitable investing, and in many cases, high-interest debt precludes any chance of your making a profit by investing.
Photo by paparutz