There are a number of factors that need to be considered when considering the best way to pay off debt.
Fact Checked byTaylor Hegna, CFP®
Should I pay off my debt? You might think this is a simple question with an equally simple “yes or no” answer. However, each person’s situation is unique, and there are a number of factors that need to be considered when considering the best way to pay off debt.
Before we can discuss some of the strategies for paying down debt, the first factor that needs to be considered is whether or not it is even financially feasible for you to pay down your debt with lump sum payments. If you’re considering making a significant lump sum payment to one or multiple outstanding loans, the first thing that needs to be considered is whether or not you have enough money in extra cash or your investment accounts to pay off your debt. If you do have the funds available, it will be important to assess the future impact of this large lump sum debt payment on your retirement plan before making any decisions. While it may be nice in the short term to be immediately debt free, if you are depleting your cash emergency fund or a large percentage of your retirement assets to make the payment, it may cause unintended negative consequences to your retirement plan. If paying off debt looks like a suitable option after assessing your current financial situation and your future retirement plan, there are some other factors and strategies to consider when it comes to paying off debt
Beyond the basic consideration of, “do I have the funds to pay off debt”, there are emotional and psychological factors to consider as well. The decision to become debt free is not one that needs to be made purely based on math. The idea of living a life free of debt is an appealing one, and one that may allow people to feel free to live the retirement they have always dreamt of having. Someone who considers themselves more risk averse may find comfort in the fact that they no longer owe anything to anyone. This might lead someone to pay off all of their debt in one lump sum payment. Someone who is more okay with risk may find it more appealing to invest the money that they would have used to pay off debt with the hopes of making more in investment returns than what would have been owed in interest on the loan.
Once you have considered the financial aspects as well as the emotional and psychological importance of your decision to pay off debt, you can start to explore some of the ways you can reduce your debt, whether in one lump sum payment, or in a strategic payment plan. When considering using excess cash, taking money out of your retirement accounts, or adjusting account contribution amounts to pay off debt sooner, the interest rate of the loan plays a big part in the decision-making process. One way to think about this decision is by projecting the return you could receive from investing the money versus the interest you pay on the loan. If you can reasonably expect to earn a higher rate of return from investing in the market than the interest rate on your loan, it may make sense to keep the loan, and use the funds you’re considering using for debt payment and invest them in one of your retirement accounts instead.
For example, if you had $100,000 that you were considering using for either paying off the remaining balance on your mortgage or investing it, looking at the interest rate of the loan will give you a good starting point in making your decision. If the interest rate on your mortgage is 4% and you think you can reasonably expect to earn a greater than 4% rate of return by investing, it may make more financial sense for you to keep your mortgage payment and instead invest that $100,000. In contrast, if you had $10,000 of money you were considering using for investing in the market or for paying off a credit card with a 19% interest rate and you do not believe that you can reasonably expect to earn a rate of return of greater than 19% by investing that money, it may make more financial sense to use that $10,000 to pay off that debt and avoid paying a potentially large amount in interest.
If you’ve come to the conclusion that, from a mathematical standpoint, it doesn’t make sense for you to pay off your debt right now, but you still want to reduce the amount you owe or speed up the process of paying off all of your debt, there are additional strategies that can be used. One seemingly simple strategy is to create a budget for yourself and make sure you’re setting aside a portion of your income to go towards debt payment.
Additionally, there are a couple strategies that can be used if you have several specific loans that you want to have a calculated approach to pay off. One of those approaches is called a debt snowball strategy. In this strategy, you make minimum payments towards all of your outstanding debt, but you throw extra money at the smallest outstanding loan. Once the smallest loan is paid off, move on to targeting the next smallest loan, putting extra money towards that each month. The amount you’re spending each month isn’t changing; rather, you’re just taking the payment amounts from the smallest loans and putting those towards the larger loans once the smaller ones are paid off. This strategy has a positive psychological effect of small victories with each outstanding loan that is eliminated.
Similar to the debt snowball, the debt avalanche strategy is another approach that could be taken to reduce your debt. This strategy is very similar to the debt snowball strategy in that you make minimum payments to all but one outstanding loan, and you throw extra money at one of the loans. The only difference is that in the debt avalanche you are targeting loans with the highest interest rate, not the smallest balance. The positive effect of this strategy is that you end up reducing the amount of interest you owe throughout all of your loans by targeting the debts with the highest interest rates and eliminating those first.
When it comes to the question of when and how to pay off debt,, the answer isn’t as simple as it may appear for every individual. There are a number of factors that need to be considered ranging from the financial impact on your retirement plan both now and in the future, to the psychological and emotional impact that becoming debt free may have on you. At Great Waters Financial we have empowered our clients to make these decisions and start their retirement out in a way in which they feel truly confident. We are always eager to help people figure out if their plan is right for them. Chat with one of our advisors about your specific debt strategy here.