One of the many questions I receive from new clients involves the elimination of debt. Should I pay off my credit card or my mortgage first? Should I make extra payments towards my student loans? What about that nagging car payment? The answer lies in understanding the question of how to prioritize debt.
Essentially, there are two types of debt: good debt and bad debt. Understanding the difference between good and bad debt will allow for prioritization and systematic elimination of debt.
Good debt is debt that utilizes some type of positive leverage. Good debt also has a component of longevity. For example, borrowing to pay for a college education is certainly good debt because there are tax benefits to the student loan interest, as well as, the education will outlast the debt. That pizza you put on the credit card six months ago is long gone, while the debt may linger. Another example of good debt would be mortgage debt. A mortgage (especially a 30 year fixed rate) will allow for leverage while utilizing the tax benefits of the mortgage interest deduction.
Bad debt can be categorized as consumer debt. This would include credit cards, revolving debt (store debt, such as a furniture purchase), auto loans, personal loans…etc. These debts offer no tax benefits and usually lead to negative financial momentum. For example, a consumer purchases an expensive car and borrows the money to do so. The payments put a strain on monthly cash flow requiring the consumer to use credit cards to purchase needed items such as food and clothing. The spiraling downturn can become overwhelming and eventually lead to financial ruin.
Once the debt is categorized, the picture becomes much clearer and debt elimination can begin. Focusing on bad debt should be the priority. List the debt balances, as well as the interest rates associated with each debt. While some so called “experts” recommend eliminating the smallest debt first, as a comprehensive planner I feel everyone has a unique situation and the debt elimination plan should be individualized. A holistic CFP® (Certified Financial Planner) specializing in cash flow and debt elimination can be a big help when it comes to mounting a charge against debt.
Debt Reduction Tips
1. Understand Cash Flow!
Debt is a by-product of poor cash flow management. Most folks don’t truly know where their money goes every month. It’s important to see in black and white the spending choices that are made. Tracking income and expenses will allow one to see where their money goes. It will also show what is left over at month’s end. What’s left over can be applied to debt, so it’s imperative to keep a close eye on cash flow.
2. Make a Commitment!
If married or in a committed relationship, it is important that all parties are working together to eliminate debt. If one spouse is savings and paying off debt while the other is frivolously spending, little or no progress will be made. Debt reduction requires thought and action, so commitment is essential.
3. Don’t Rush to Eliminate Good Debt!
The good debt discussed above can actually have financial benefits, so don’t rush to eliminate that debt, especially mortgage debt. For example, a 30 year fixed-rate mortgage is a debt I recommend to most of my clients. This mortgage creates a great inflationary hedge. A long term fixed debt will allow the homeowners to make tomorrow’s mortgage payments in today’s dollars, so don’t rush to eliminate this debt. There may be better use of your dollars.
4. Know How Much You Can Afford!
While good debt has benefits, it is important to utilize this debt properly and not overspend. This is especially true in purchasing a home. While I am an advocate of 30 year fixed rate mortgages, I am not an advocate of over-buying real estate. Knowing how much to buy is imperative. Creating an inflationary hedge and utilizing the tax breaks offered from a mortgage will do no good if the homeowner buys a house they cannot afford.
Debt usually stems from behavioral choices, so before any debt reduction can begin the behavioral issues need to be resolved. In essence, living within your means is the first step. Another key component to debt reduction is understanding personal finances from a big picture view. Financial planning is equivalent to a giant puzzle and all pieces should work together to meet the end result, so a synergistic approach should be taken. Taxes, cash flow, interest rates, type of debt, and other issues should all be considered before a debt reduction plan can be put to work. A qualified financial advisor may be needed to tackle debt reduction with a synergistic approach. The Alliance of Cambridge Advisors (ACA) is a great organization of comprehensive planners that can assist is debt reduction strategies. More information can be found at www.acaplanners.org.