Dealing with DebtSubmitted by Affiance Financial on January 8th, 2018
Starting a new year is often the perfect catalyst for revitalizing your ambition to tackle those tasks which you otherwise just can’t seem to get started on. If you’re feeling nagged by student loan or credit card debt, this article may help you develop a plan that will set you on the path toward a worry free relationship with debt.
Finding the best strategy for tackling your debt can potentially mean the difference of thousands of dollars, and more importantly, a good night’s sleep. But first, it’s important to understand the different types of debt and how interest affects it.
Good Debt vs. Bad Debt
Believe it or not, there is such a thing as good debt. Good debt is an investment in yourself — such as education. This is good debt because in time, the investment will pay for itself. In the case of education, you’re anticipating receiving a higher salary for having more schooling. Other types of good debt include mortgage and business debt. Typically, good debt will have a low interest rate.
Bad debt is using borrowed money to maintain a certain lifestyle. The two most popular forms of bad debt are credit card debt and auto loans. These are bad debts not only because it's spending money on things that won’t necessarily help you in the future, but they also usually carry a high interest rate.
"Compound interest is the eighth wonder of the world. He who understands it, earns it... he who doesn't... pays it." — Albert Einstein
Another important factor when deciding how to tackle debt is interest rate, and how it is compounded. Compound interest is defined as: “interest calculated on the initial principal and also on the accumulated interest of previous periods of deposit of loan.” A common way of looking at it is earning interest on interest — or paying interest on interest — as opposed to earning or paying interest only on the principal investment or debt, which is known as simple interest. Interest is typically compounded monthly or annually. The more frequent the compound, the faster it grows.When a loan uses compound interest, it’s vital that you pay the monthly interest charge. If you don’t, that interest will compound either monthly or annually, depending on how the loan is structured, and grow to an overwhelming debt. This is why it’s so important to make sure you’re at least paying the interest on your loan.
Student Loan Debt
Contrary to popular belief, paying off your student loans as fast as possible isn’t always in your best interest. Because student loans are good debt, and the average interest rate is a modest 4.45%, you may find a higher return on your money elsewhere. To illustrate this, I’ll go through the three primary repayment options.
Let’s say you have $100,000 in student loan debt at a 4.45% interest rate, and your minimum monthly payment is $1,036 (based on a standard 10-year repayment plan). At the end of each month, you have $1,500 to use however you like, but of which you have to at least make your minimum monthly payment on your student loans.
The first option for repaying your debt is to make the $1,036 minimum monthly payment and spend the extra $464 on maintaining your lifestyle. By following this strategy you would pay off your loans in ten years, and pay $24,366 in interest. This is the most costly strategy.
The second option is to put all $1,500 toward your student loan debt each month. In this case, your loans would be cleared in just over six years, and you would pay $15,223 in interest. This is the fastest approach to paying off your loans.
The third option is to make the minimum payments of $1,036 per month, and invest the extra $464 elsewhere. If you were to invest that $464 every month, and it grew at an average rate of 7% compounded annually you would earn $77,842 after ten years. This is especially effective when the money you’re saving is going into a tax sheltered account, such as a 401(k) and far outweighs the extra $24,366 you would owe in interest for taking longer to pay off your student loans. This is the most financially beneficial plan, though you will carry your loans for 10 years.
Despite what these numbers tell us, the biggest factor in deciding how to repay your loans is whether you approach your finances emotionally or unemotionally. If you are not emotional about money, and look at your finances in a completely logical sense, you may be better off paying the minimum monthly amount; and investing any extra dollars toward a different goal, such as financial independence, housing, or even saving for your kid’s education.
If you’re simply unable to sleep at night due to the anxiety associated with your student loans, you may want to pay your loan more aggressively to ease the stress.
To get an estimate of what your monthly payments could look like —
- Find your debt info here: https://www.nslds.ed.gov/npas/index.htm
- Plug it in here: https://studentloans.gov/myDirectLoan/mobile/repayment/repaymentEstimator.action
- See how much your dollars can earn using compound interest here: free compound interest calculator
Credit Card Debt
A recent study by NerdWallet finds that Americans have reached a staggering $905 billion in consumer credit card debt, making the average credit card debt $15,654 per household.
Unlike student loans, it’s almost always best practice to pay off your credit card debt as soon as possible. This is due to the much higher interest rate associated with credit cards; ranging from 14 to 22% on average, compared with just 4.45% for student loans. This higher interest rate means the potential for getting a better return on your money elsewhere is less likely.
To show the difference each strategy can make, I’ll go through a few of the most popular repayment options.
For our example, we’re going to assume you have two credit cards, which both hold a $4,000 balance. Credit Card A has a 20% interest rate, while Credit Card B has a 16% interest rate. At the end of each month you have $400 for savings, of which you must at least make your minimum credit card payments.
The first option is to simply make the minimum monthly payment on both credit cards. Although this is the most inefficient strategy – that is, it costs the most and takes the longest, a 2015 study found that 29% of credit card accounts regularly make at or near-minimum payments.
How minimum payments are calculated varies from company to company. For this example, we will use a common formula that incorporates interest —
minimum = 1%(balance) + interest (with a minimum dollar amount of $25)
Your monthly interest charge will be calculated as —
interest = APR(balance) / 12
After calculating the information above, here are the results:
As you can see, this is an incredibly inefficient way of dealing with your credit card debt. Because your minimum payment is relative to the percentage of your balance, your minimum payment decreases in parallel with your balance — maximizing the life of your debt. By only making the minimum payments, you will pay more than $8,000 in interest over a span of 17 years.
Highest Interest Rate / Fixed Payments
The second option is to aggressively pay off your highest interest credit card (Credit Card A) while setting a lower (or minimum) monthly payment on the lower interest credit card (Credit Card B). Then, once your highest interest rate card is fully paid off, focus all of your budgeted dollars on the lower interest credit card. This is considered to be the most efficient, cost-effective plan (not including using a balance transfer).
In this case, the monthly payment for the highest interest credit card was set at $300; with the remaining $100 going toward the lower interest credit card.
After 16 months, the highest interest credit card was fully paid off — accruing a modest $561.66 in interest. Next, we focused all $400 in the budget toward the lower interest credit card. With a lower interest rate and part of the balance already paid off, Credit Card B was paid in full in 9 months — accruing just $203.62 in interest.
Compared with just making the minimum payments, this strategy saved you $8,583.48 in interest and 15 years of credit card payments.
The third strategy is for when you have two credit cards that have a significant difference in balance owed. Studies show that those who feel overwhelmed with the task of taking on such a large balance may benefit from focusing on the credit card with the lowest balance, regardless of the interest rate. The reason for this is that after you feel that sense of accomplishment from paying off your first credit card, you will be ready to take on a bigger balance.
Obviously, in a strictly financial sense, this is not the best strategy — as the larger debt will most likely have a higher minimum payment associated with it.
Nonetheless, if you’re feeling overwhelmed by the idea of taking on a significant balance, starting with something a little easier to manage may be the best strategy for you.
Another helpful strategy — available if you have good credit — is to transfer your existing credit card balance to a 0% intro APR (annual percentage rate) credit card. This strategy works well if you have a high interest rate keeping you from making any real progress on paying off the principal. Most of these credit cards allow you to make payments on your debt for a set amount of time (usually over a year). Although some cards offer a free balance transfer within a set time period from when you activate your card, it’s not uncommon for them to carry a 3% balance transfer fee. To explore your options for transferring your balance to a 0% intro APR credit card, check out this article by Credit Karma.
Similar to paying back student loans, choosing the right strategy to repay your credit card debt partly depends on the debt holder. How many credit cards you have, the different interest rates attached to them, and whether you approach your finances emotionally or unemotionally all factor into the decision.
To test different strategies for paying off your credit card debt, try this free calculator.
It’s Up to You
There are many different strategies for paying off debt. Choosing the one that is right for you has everything to do with what will allow you to sleep at night. Some people are comfortable growing their assets as much as possible, even if that means holding onto their debt for a little longer. Others may want to be debt free as soon as possible, and then start building their wealth with no strings attached. The important thing is to have a plan. If you’re interested in learning more about your specific options, contact your financial planner today.
All investments have the potential for profit or loss. Investors should consider the investment objectives risks, and charges and expenses of each investment carefully before investing. Historical performance results were presented for illustrative purposes only and are not intended to imply the potential performance of any investment.
The views represented are not meant to be construed as advice. Moreover, no client or prospective client should assume that this content serves as the receipt of, or a substitute for, personalized advice from Affiance Financial, or from any other professional.