What to do? Cut down the credit card debt or pay off the student loan? Work on the home equity line of credit or pay off the car loan? It's a great thing to pay off the money you owe but paying off some debts have more benefits than placing your focus on others. Here is our expert opinion on how you should approach your situation of having many loans.
Good Debt vs. Bad Debt
Know and understand the kind of debt with which you are dealing. A home loan or a student loan is considered to be "good debt." The reason they are called good debt is that they can boost your financial situation. Also, there are some student loans and some types of home loans that may be tax deductible. For example, an investment property has quite a few tax concessions. Don't pressure yourself to pay these loans off as long as you can make your regular monthly payments.
On the other hand, anything that does nothing to improve your financial position, and that you can't pay off in full within a couple of months can be called bad debt. For example, a fancy meal at an expensive restaurant or a birthday gift for your partner. Personal bank loans or any form of credit card debt is usually a bad debt. These are the debts you should tackle first.
Work out what will help you the most. Looking at it from a financial angle, it makes more sense to pay off the bad debt that has the highest rate of interest. For example, putting $500 towards a $3000 credit card balance that has an 18% interest rate is going to save you more money than $500 towards a bill at 6% interest rate.
However, you might want to wipe out the smaller bill entirely to give you a bit of psychological satisfaction at being able to do it. A small win like that can fill you with motivation to stick with your debt payment program.
Example Credit Card Debt - $3000. APR - 15%. Minimum Monthly payments - $60
Pay an extra $100 a month, so you pay $160 a month, and the amount is paid off in 1.8 years with a total interest of $391.
Estimate Your Credit Score
Think about the effect on your credit score. It's worth paying down credit cards that are almost at their limit if you have plans to buy a home or a car. It's to do with lowering your 'utilization ratio' as this has a positive impact on your credit score.
That means you may be considered for lower interest rates. If you look at the example above, after 1.8 years you then have $160 extra dollars available to place onto another loan.
Example: Auto Loan - $20,000. APR – 8% over 5 years. Minimum Monthly payments - $406.
Take the extra $160 and add to the auto loan repayment of $406 making it $566 a month. You pay off the loan in 4.3 years and pay $3,855 interest.
Available Strategies After Paying Off Bad Debt
You can see from the calculations in the above examples that you are decreasing the loan period initially contracted, paying less interest, and freeing up debt payment money for you to use in other ways.
The strategy now is to take the extra money you have each month, $566, and use it to pay off the good debt – home loan and student loan. The returns on these two larger loans will have you scratching your head in wonder as to why you didn’t think of doing this a long time ago. You have a bit of momentum up now and attacking the bigger loans won’t seem as daunting.
Example: Student Loan After killing the credit card and the car loan, you now have $566 to place onto your student loan. Student Loan- $15,000. APR – 5% over 10 years. Minimum monthly payments - $159.
Take the extra $566 and add it to the $159 making it $725. You will pay total interest of $2,735 and have the student loan paid off in 5.2 years.
Example Home Loan. Loan amount - $200,000. APR – 4.5% over 30 years. Minimum monthly payment $1,013. Add the $725 to that making it $1,738. You pay off the loan in 16.2 years, almost halving the loan term. And the interest has gone from $164, 680 to $92,129. Savings of about $72,000!
Warning! Don't be tempted to pay off high-interest credit card debt by borrowing from your 401(k) or by taking out a home equity loan. It's not a smart move. You could lose your home if you default on the home equity loan. You can miss out on some valuable tax benefits if you borrow from your 401(k).
Also, if you quit or lose your job, you will be asked to repay the full amount you borrowed within three months or face some harsh penalty.