Linda @ The Cents of Money
When aiming to accumulate and conserve wealth, be ready to tackle some tough choices and trade-offs. Your planning should start as early as possible so that you have a reasonable early start on your roadmap to accumulate wealth, have financial flexibility, and retire comfortably. It’s challenging to build wealth if you carry a lot of debt.
You need to pay off your debt wisely to strengthen your financial health. You will likely accumulate debt in your life, but you need a plan to pay it off so you aren’t carrying a burden you can’t handle. Review your credit report and score ahead of borrowing for a college education, furthering your career, or buying your home for the best interest rates.
Pay Down Your Debt On Time
Jumpstart your children’s college education by investing in 529 savings plans for your child’s education as early as possible. This will lessen your future debt burdens while lessening theirs.
Plan to get federal loans before seeking private loans. Apply for scholarships, grants, and work-study programs. Most importantly, make sure you and your children understand how to repay your obligations on time.
Buying A Home
Before actively looking to buy a home, make sure to check your credit reports first to see what kind of financial shape you are in. Make sure it becomes a regular part of your life to habitually check your credit reports and score. You may be able to raise your credit score and obtain a lower interest rate. Also, it is not uncommon to find errors or issues which can be corrected but it takes time. You should deal with it quickly.
A Shorter Mortgage May Be Beneficial
When buying a home, consider opting for a shorter-term mortgage as your total cost will be lower and ends sooner.
Let’s use an example to illustrate what your mortgage costs will be:
Assume you found an $800,000 single-family home, putting a 20% down payment, or $160,000. In both mortgages, you are borrowing $640,000, the principal amount you will owe. At a recent rate of 6.918%, your monthly payments will be quite different for a 15 year fixed mortgage than a 30 year fixed mortgage.
For example, assuming a 15-year fixed mortgage rate you’ll be making monthly payments (excluding taxes and fees) of $4,222,75 compared to $5,723.20 payments for the 30-year fixed rate.
The total interest cost for your home is even more pronounced on the shorter mortgage, totaling $390,176.11, and including the principal amount of $640,000, your home amounts to $1,030,1756.11. On a 30 year fixed mortgage, your interest costs will be significantly higher at $880,189.67, and adding the $640,000 principal, your home costs are at $1,520,187,67.
While it would be nice to get a price pop on your home, remember you are living in it and hopefully enjoying the house. If you are fortunate to get a low mortgage rate for a shorter timeframe, this will be a good way to pay off debt.
Good Debt versus Bad Debt
While using debt for student loans and mortgages can be painful to bear, they are helpful for building your future, and often considered good debt.
On the other hand, paying off only the minimum amount of your credit card bills causes your balance to expand significantly with high interest payments (at high teens or more) . Don’t overleverage yourself with credit card debt. Make rules you can keep. Pay off your credit card balances in full every month so you won’t have any interest charges at all. Paying the roughly 2.5% required minimum on a $3,000 balance can take over 20 years to pay it off.
APR vs APY
A credit card’s interest rate or the annual percentage rate (APR) is the price you pay for borrowing money, and it is usually the highest rate (high teens percentages unless you have great credit) you will pay. Far higher than for mortgages or for student loans. The APR doesn’t include the compound interest rate.
On the other hand, the effective annual rate on the annual percentage yield (APY) does include how often interest is applied to your balance (eg. daily, monthly quarterly, or yearly). This means that when you don’t pay your card’s monthly balance in full, you are paying interest on interest. Here, compound interest is working against you, building up your debt amounts.
Remember these credit cards interest rates are higher than mortgage rates. Depending on your credit score, and whether you are an existing cardholder or a new cardholder your APR could range from 15%- 25+%. If you miss the monthly minimum, you will pay dearly after 30 days of nonpayment. You will incur a penalty rate upwards of 29.99% monthly until you make six consecutive payments on time. You will also pay flat fees, and your credit score will be impacted negatively.
Ouch!
If you can’t pay your monthly card bill in full each month, cut your spending. When you pay only the minimum balance on your cards, you will be wearing a financial noose around your neck for longer than you want.
Two methods to reduce debt: the Avalanche Method and the Snowball Method
Assuming you have the following debt balances:
- Credit card debt of $3,500 @ 15%
- Student federal loan#1, of $5,000 @ 4.5%
- Student private loan#2, of $7,000 @ 7.5%
- Car loan of $13,000 @ 5%
- Miscellaneous debts of $1,500 @ 4% average rate
Using the avalanche method, your priority would be to pay down your debt that is most costly first. That will likely be your credit card balance by targeting the credit card debt at the higher 15% rate.
If you are only able to pay $1,000 per month, it would take you 3.5 months to bring down your balance to zero.
Mathematically, the avalanche way makes sense to rid yourself of high-cost debt. That debt grows faster and your total interest costs will likely be lower using the avalanche method.
The snowball method is gentler. Here, you begin to pay down your debt, looking for the smallest amounts first, and tackling larger amounts afterward. This should motivate you to get into the habit of paying down debt and feeling accomplishments sooner. Here, you would pay the smaller amounts in the miscellaneous total before challenging yourself with the bigger amounts at higher rates. You will likely be paying more in total borrowing costs.
Which method to use?
Guru Dave Ramsey has been a proponent of the snowball method. Academic studies back this method. The anxiety of having a lot of bills can paralyze debtors from doing anything at all. Tackling bills one at a time can be an accomplishment and is motivating.
One of the most recent studies out of the National University of Singapore by Dr. Ong Oryan suggested that “getting rid of debt clears up cognitive functions, lessens anxiety, and improves impulse control.” The study pointed out that debt impairs psychological functioning and decision-making.
One way to look at debt reduction is to look at it as a trade-off in investments. When you pay off debt with higher interest rates of over 15%, it is like making a 15% return! That already feels like an easy choice.
For those who are highly motivated, analytical, and ready to take on the task to lower their borrowing costs, the avalanche method is better.
It is truly a personal choice. The best choice is to get started on addressing your debt so you can move on to better financial health.
Ways to find the cash to pay down your debt:
- Annual tax refunds
- Sale of an investment earning lower returns than what you are paying
- Your annual bonus
- Spending below your earnings and resultant savings can help
Managing your money requires financial discipline. High debt levels disrupt our plans for wealth accumulation and need to be dealt with firmly.