It’s the holiday season and it seems everybody is in a good mood. Christmas cheer is in the air and the stores are full of eager shoppers looking for that perfect gift. Another occurrence that’s not so pleasant around this time of the year is people are racking up that holiday credit card debt. If you’re like me you tend to spend now and worry about the payments in January.
Today I’d like to talk about a common strategy that financial planners use to help clients pay down debt. It provides an organized system for paying off loans based on using your money in the most efficient way possible to help you get financially fit in 2016.
Let’s Get Serious
Paying down debt is no joke. Carrying debt can make or break your financial future and that’s why it’s as serious as a heart attack. I want you to not just pay debt I want you to attack it. Theres nothing worse than having loans or credit cards hanging over your head.
The first part of this equation is you figuring out how much you owe on each debt. Next, find out the interest rates on the debt. Now you will list your debts in order with the highest interest rate first.
- $5,000 Credit Card @ 18%
- $2,400 Credit Card @ 10%
- $15,000 Student Loan @ 6%
- $10,000 Car Loan @ 5%
You want to pay the debts one by one starting with the highest interest rate. If you have $200 a month to put towards debt then pay that $5,ooo credit card bill until it disappears. For all the other debts, pay the minimum payment. One by one, you’ll crush the debt efficiently. When you use this strategy you save yourself a lot of money in interest.
There are a couple of exceptions to this method. If you have one debt that is much smaller than the rest, say a $500 credit card bill, I want you to pay that off first. It feels great to smash debt so if there is something small you can get rid of in a month or two you should do it. Also if you owe back taxes I would always pay those first. You don’t want the feds looking over your shoulder for any longer than they have to.
A Bit About Student Loans
I’d like to address a question that my mom asked me. Say you have two student loans. Loan 1 has an interest rate of 8% but is tax deductible. Loan 2 has an interest rate of 4% but no tax deduction. Should you not pay down the tax deductible loan because you’ll just get the money back at the end of the year?
My answer to this is, in general, is no. You should still pay off the higher interest loan. When loan interest is tax deductible it doesn’t mean you get the exact amount back that you paid in interest, it merely means your taxable income will be less. For example:
I make $30,000 per year
I paid $1,400 in interest on my Federal Stafford loan
My taxable income will now be $28,600
The difference in taxes would be $4,500 vs $4,290 at the end of the year.
The tax saving isn’t that great compared to how much I actually had to pay in interest. If I choose to not pay Loan 1, I will end up paying much more in interest over the life of the loan. Sure, a portion of that is tax deductible but it’s not like I’m getting all my interest money back. What if both loans carry the same interest rate? In that case I would pay the non-deductible loan.
It’s All Up to You
Paying off loans can be amazingly freeing. Back when I worked as a hostess at the airport cafe I had a $5,000 student loan that I felt I would never get rid of. I got on track and threw all my money at that loan for a good two years before I could pay it off in full. When that loan was gone it freed up a lot of extra cash for me and in turn I put that extra cash in savings.
Tackling debt is about changing old behavior. You make one good financial decision at a time. Being smart about money is very much like a puzzle. Put together some good choices with financial planning and you get there before you know it. I guarantee you once you start seeing debts disappear it will motivate you that much more to kill the rest of the debt.