Paying down debt? Here’s what you need to know
Which is more important: paying off debt or saving for the future? If you already have a significant amount of debt and not a lot in savings or investments, it can be hard to figure out which should be a priority. In this article, we discuss how to pay off debt while still setting yourself up for a financially sound future.
Is there such a thing as good debt?
Yes! Loans, when used properly, enable a lot of life’s milestones. Buying a house, paying for college and even buying a car are all examples of how incurring some debt in the short term can actually increase your potential net worth down the line. As you think about paying down your debt, keep in mind that not all debt is created equally — and, therefore, should not be paid off in the same way. The table below describes some general characteristics of good versus bad debt.
|Good debt||Bad debt|
|It has a low interest rate, and it’s a bonus if the interest is tax deductible.||It has a high interest rate.|
|It’s used to buy something that has value, may increase in value or will help generate income.||It’s used for something that doesn’t have future value.|
|It doesn’t push your total debt levels too high.||It pushes your total monthly loan payments (not including your mortgage) to more than 20% of your monthly income.|
How do I know if I have too much debt?
To know if you have too much debt, you first need to assess the debt you currently have. Take note of balances, interest rates, monthly payment amounts, when it’s expected to be paid off, tax deductibility and any other important features. This sounds simple, but we know it can be overwhelming. Feel free to take it a small step at a time until you’ve compiled the critical information about all your debt.
Next, you need to determine your debt-to-income (DTI) ratio. To calculate your DTI ratio, divide your monthly required debt payments by your gross monthly income. If you’re paying a mortgage, try to keep your DTI ratio at 35% or less. (Without a mortgage, strive for 20% or less.)
Your debit-to-income (DTI) ratio can be a great predictor of your financial health. The higher the number, the higher the percentage of income being used to pay off debt. If you have a higher DTI ratio, you may struggle to make ends meet, have trouble securing loans for big purchases such as a home or may be forced to accept higher interest rates on those loans.
Should I prioritize paying off debt or saving/investing?
It depends on the type of debt you have and what you currently have saved. Paying off your debt as fast as possible may seem like the responsible thing to do, but not having an adequate emergency fund or saving for your future could leave your finances at a permanent disadvantage down the road.
Here’s how we suggest you prioritize paying off your debt without sacrificing your other financial goals:
- Start by maximizing your available savings. It’s a good idea to create (and stick to) a budget so that you can maximize the amount you can put toward paying down debt or saving. Keep in mind, you should always be making at least the minimum monthly payments on your debt. When budgeting, make sure to account for expenses that don’t occur on a regular basis, such as your car insurance and annual subscriptions. Also, look for opportunities to reduce or eliminate some unnecessary expenses. A good place to start is any unused or redundant subscription services or memberships.
- Make progress toward an emergency savings fund. Eventually, the goal is to have three to six months of expenses in an emergency savings fund, but when you’re starting out, you’ll want to balance building toward this with paying off debt and saving for retirement. Focus on having at least $500 to one month of expenses in emergency savings before paying off debt. This can help you prepare for the frequent, smaller unexpected expenses we all encounter such as a minor car repair or medical bill.
- Take advantage of any employer match in your retirement plan and health savings account (HSA). If your employer sponsors a retirement plan, be sure to contribute at least the amount your employer will match in contributions before paying off debt. For instance, if your employer matches up to 3% of your contributions, you should contribute at least 3% of your income to this retirement account. When they match your contribution, the balance you have with the potential for market appreciation goes up. Additionally, some employers will match a portion of your contributions to an HSA. Eventually, you’ll likely want to get to a point of saving more than just the match, but you’ll have to weigh the benefit of additional retirement contributions against the cost of any debt you're carrying.
- Then consider tackling your debt, starting with high-interest debt. High-interest, nondeductible debt, such as credit cards, is likely to cost you more in interest than you can expect to earn on your investments. So, you’re better off to start paying down this debt first. If two loans have the same interest rate, pay off the one with the lower balance first since you can pay it off quicker, negating an entire monthly payment in the process and lowering your debt-to-income ratio. As you get to lower interest-rate debt, you’ll have to consider the trade-offs of paying that debt down versus investing for future goals.
To make achieving these goals easier, automate as much as you can. For example, you can divert part of your paycheck into an emergency savings account or a retirement account and set up automatic payments for any debt.
While it may seem like a huge endeavor to pay off your debt while still saving for the future, it doesn’t have to be. Taking small, incremental steps is key to getting to where you want to go. Plus, your financial advisor is always here to help you put together a strategy to help you achieve your financial goals based on your unique needs and circumstances.