Which debt should I pay off first?
It’s the reality of modern life that at some stage, we will all have debt. This may be an investment debt, a home loan or a credit card debt. Regardless, this means at some point we will all be faced with questions about how best to manage this debt. This includes how and when we should pay it down and how we can juggle the situation when we have a few debts. Debt can be a powerful tool. It can allow us to have a house to live in, to increase our investment gains or cover us during periods of shortfall. Unfortunately, debt can also have a very negative affect when used in the wrong way.
A question I get asked regularly is which debt should I pay off first? Part of our process at Bounce is that we will model out your lifestyle expenses in comparison with your income and identify whether you are in a net positive or net negative position i.e. are you earning more than you are spending or vice versa. If you are spending more than you are earning, we will work with you to identify where you can cut back or increase your earnings to get in a positive position.
Once you’re in a positive position, we will start directing your excess income towards your goals. For many people this involves paying off their debt.
Why would you want to pay off your debt? I know this seems like a simple question, but it isn’t a simple answer. A lot of people want to start saving or investing and getting ahead with their money. Whilst this is a great goal, with debt in the picture, each month you are being pulled down by interest payments forcing you further and further away from your ultimate goals.
So back to my original question, which debt should I pay off first? I’ve seen people attempt to pay their debt off in various ways with the most common being for people to pay the smallest debt first. Whilst I understand the psychology behind this, paying off the smallest debt might end up costing you in the long term.
How to assess your debts
Not all debts are made equal. The first question you need to ask yourself is whether this is ‘tax deductible’ debt. Tax deductible debt is debt you have taken on to invest in something. The most common is either an investment property loan or a loan to buy shares. I’ve regularly seen tax deductible debt referred to as ‘good debt’. Whilst I wouldn’t go as far to suggest any debt is good, this is by far the preferred debt and in most instances should be paid off last. That being said, the goal should always be to still pay this off.
If your debts are for personal things such as your home loan, personal loan or credit card, the next question you need to ask is which one has the highest interest rate. Again, this question may seem straight forward, but the answer isn’t always. What if you have recently done a balance transfer on your credit card and your interest rate is low or 0%? Should you pay this last? This isn’t always the case, as regularly these kind of credit cards increase the interest after a period of time, regularly to a very high interest rate.
Another question that arises is should I pay off my home loan or start investing? The answers are all individualised and we work with our clients to formulate a plan that balances the best financial outcome with the lifestyle they want today. In general, I would always recommend paying off your credit card. Our most successful clients don’t have credit card debt. The same goes for personal loans. It’s astounding some of the amazing things we can achieve for clients when they have little or no credit card or personal debt. In relation to your home loan, that is a little more complicated topic.
So in summary:
- Pay off your credit cards and personal loans first (whichever has the higher interest)
- Once you start moving to your home loan or investment loans, either seek advice or take the time to formulate a plan on how to address this debt.
As always if you have any questions, please feel free to reach out. I’m always available to have a chat.