Should I pay down some of my credit card debt or should I pay off more of my student loan? Do I build more equity in my house by paying down more of my mortgage or do I pay off my auto loan early? There are many different forms of debt and paying off your debt and cutting the ties with creditors is the first step in obtaining financial freedom. I always tell people that they should invest early, however, that advice sometimes comes with a caveat which arises when someone has debt. There are different forms of debt and not all debt obligations were created equally, so we will go into detail to help you determine which debt you should pay off first.
Step One: Know what kind of debt you have
Before you start investing, I recommend having eliminated all your credit card debt. Why? Well, it’s simple math: your credit card will typically charge a higher annual return than you get in the market. Credit cards can charge up to 29.99% interest rates (not to mention all the fees and additional charges that can be associated with them) while the market earns an annualized return of 10%. If you invest money in the market and earn a 10% return while you still have outstanding credit card debt with an interest rate of up to 29.99% then you could be losing almost 20% on your money. Another form of “bad debt” would be a personal bank loan, and just like credit cards, they usually are accompanied by higher interest rates On the other hand, things like home mortgages and student loans are considered as “good debt”. That’s because those are considered appreciating assets. As you pay your mortgage on-time, you are building your equity in the home and student loans enable you to achieve higher education, which indicates better job opportunities and higher compensation in the future. Auto loans, assuming you don’t have an outlandish interest rate, can be a good way to finance a large purchase. An auto loan isn’t really considered “good debt” but isn’t necessarily considered “bad debt” – that’s because while you are building equity in the car by paying off your loan, it is a depreciating asset that loses value over time.
Step Two: Which will help you save the most money
As a rule of thumb, it is usually better to pay off your highest interest rate debt first. Usually, this means paying off your “bad debt” first – so your credit cards or any personal bank loans should get nixed first. Think about which will save you more money: paying off $1,000 on a credit card bill charging a 23% interest rate or paying off a $1,000 bill charging 5% interest. If you don’t have anymore “bad debt” and you want to pay down some of your “good debt” then I would look at which interest rate is higher and how much longer it will take to pay off the loan. This is because on a traditional loan, in the beginning, you are usually paying more towards interest than you are towards the principal. On a 30-year mortgage, your first payment is usually 80-90% interest charges while only 10-20% goes towards the principal.
As you pay on-time each month, you begin paying less towards the interest and more towards the principal. I tend to lean towards paying off your home loan first because 1.) the amount you overpay your loan by each month goes to paying off your principal (meaning you will have to pay less interest in the future) and 2.) as you pay off your home loan you are building equity in your house and increasing your net worth. It should also be noted that you can’t really build equity in your student loans – you already received your education/ your degree (it is not like you receive your degree only once you have paid off your student loan). I also lean towards paying off your home loan first because while your house can be foreclosed on, your student loan cannot be.
Step Three: Consider your Credit Score
Most people don’t have extensive knowledge on the ins-and-outs of their credit score or even the components that make up their credit score. First off, I always suggest checking your credit score regularly. I check my credit score daily on Credit Karma (it’s 100% free and it doesn’t affect your credit score to check it). This last step is really only super important if you are about to make a large purchase and you are applying for credit (such as an auto loan, a mortgage, or if you are financing another large purchase). This is because your credit score will directly affect the interest rate the creditors offer you. Think of your credit score as a report card of sorts, a high credit score indicates to a bank or creditor that you are more likely to pay them back aka you are less risky and thus, they charge you a lower interest rate. On the other hand, if you have a bad credit score, you are deemed a riskier customer and a creditor may not trust that you will pay them back, and thus they either have tocharge you a higher interest rate or they will not let you borrow money at all. Your credit score is merely a snapshot in time and can change daily so knowing how to “game” the system so that you have the best credit score possible when applying for a new loan can be the difference in thousands and thousands of dollars over the life of the loan (if we are talking about a 30-year mortgage especially). To understand how to game the system you need to understand the makeup of your credit score – of the main credit reports your FICO score is the most commonly used. Your FICO score is comprised accordingly:
• 10% - New Credit
• 10% - Credit Mix
• 15% - Length of Credit History
• 30% - Credit Utilization
• 35% - Payment History
The category I want to focus on is the credit utilization section of your credit score which makes up 30% of your score. Why? Because New Credit and Credit Mix don’t necessarily change day-to-day and Length of Credit History and Length of Credit History will increase with on-time payments over time but it takes a lot of time to build those up. Your Credit Utilization on the other hand, is just a snapshot of 1.) how much money you currently owe and 2.) how much of your available credit you are currently using. The rule of thumb for credit cards is ALWAYS stay at less than 30% credit utilization—meaning if between all of your credit cards, if you have an available spending limit of $10,000, you should never carry a balance of over $3,000 (note: you can go over 30% if you are making a large purchase with a credit card because you receive cash back, points, airline miles, or other rewards – but ONLY if you have the cash on hand to pay off the purchase immediately). Additionally, if you are using only 30% of your available credit but you have a credit card that is maxed out or utilizing a very high percentage of its available credit, then pay that off as well because the score not only factors in your total credit utilization amongst all accounts but also your credit utilization of each individual account. Additionally, as you get closer and closer to paying off an installment loan, (like a home, a car, or a student loan) the higher your credit score will become — because the amount owed on the loan decreases, while your length of credit history and your repayment history increase simultaneously. However, once you completely pay off those loans your score may actually decrease briefly because that loan is considered a closed account. A closed account could affect your length of credit history (especially if that was your oldest account or only account), as well as your credit mix (because you now have one less open account contributing to your credit mix). So, while paying off your installment loans is considered good, the timing of when you pay it off is also important. The amount of interest being saved by paying off the loan early is really marginal if you are at the end of your loan’s life and some would say the increase in your credit score can outweigh the few dollars you could save by paying off your loan early.
I hope this article clarified the different kinds of debt and hopefully it can help you determine which debts to pay off first. Determining which debts to pay off first can mean that you save hundreds or even thousands of dollars over time which is why it is important for you to determine which debts and loans you should eliminate first and which ones can stay on your balance sheet for the time being.