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Maybe you started your financial journey, like so many, net negative thanks to expenses like student loans, a car loan, or miscellaneous credit card debt. Perhaps unexpected life events or a lack of time to focus on your finances – whether due to health issues, employment changes, or other happenings – prompted debt accumulation that grew over time. The idea of considering investing for the future or retirement may seem daunting since you first need to get to zero before considering how to accumulate a positive net worth. If any of this describes your current situation, there is only one solution: Stop worrying about the oppressive weight of debt, and start getting rid of the debt!
Pay Quickly or Pay Slowly?
The urgency of paying off all debts is not equal. In fact, there are some debts for which paying the monthly minimum is the smarter option. Whether you should pay your debt off as quickly as possible or slowly, over its planned term, depends on three variables: (a) the interest rate of the debt, (b) the rate of return you could get if you invested the money instead, and (c) your risk tolerance.
Determining the interest rate on the loan is easy to analyze. Just look at your account to see the interest rate. Debts like mortgages generally have the lowest interest rates while credit card debts range much higher. Student loans and car loans tend to fall somewhere in the middle.
The rate of return you could get on an investment is more difficult to anticipate. This is the amount your money would grow if you invested the money instead of paying off your loan. If you would put the money in a high-yield savings account (HYSA) or a certificate deposit (CD), the rate of return is likely low, around 2-5%. However, if your alternative is to invest that money in index funds or real estate, you may be able to realize rates of return around 8-10% or more annually.
Simply put, this is the formula for when you should pay off debt slowly or quickly:
Debt Interest Rate > Anticipated Rate of Return on an Investment → Pay Quickly
Debt Interest Rate < Anticipated Rate of Return on an Investment → Pay Slowly
Of course, some debts also have tax implications, and income is generally taxable. You can use the “after-tax” rates in the above formulas but the same basic principle applies. Unless your finances are complex, though, the tax impact of this comparison is probably minimal, if any.
The final variable is your own risk tolerance because it determines the anticipated rate of return to use in the above formula. If you have a lot of debt, or want to weigh your options safely, comparing to a HYSA or CD rate of return is prudent. However, if your debt is lower, you are knowledgeable about real estate, and you feel confident in a recent investment, your calculations may vary. Only you can assess your own risk tolerance. If you have no idea what your own risk tolerance is, play it safe: If the interest rate on your debt is over 4-5%, pay it off quickly.
Here is an easy example: Our mortgage interest rate is 2.75%. Should we pay it off quickly? The current rate of return on our HYSAs is 3.3%, without any risk of market fluctuations. That means our HYSAs are making more money in interest than our mortgage is accumulating. We should pay our mortgage off slowly since we would actually lose money by paying it off quickly! (That could change if the rate of return on our HYSA changes, but the mortgage rate is locked in for the life of the loan.)
However, the calculation changes a bit when you consider whether to pay your student loan with a 6% interest rate off quickly or slowly. While only you can decide what is right, if you have relatively few assets, compare that interest rate to the rate of return on a HYSA or a CD. Since a HYSA or CD will probably not give you a rate of return higher than 5% right now, pay that student loan off quickly.
Prioritizing Debts
Having multiple debts complicates your analysis since you need to determine which to pay first. There are two competing methods for prioritizing which debt to pay first. One is the mathematically prudent one, meaning it saves you the most money. The other was devised to help folks psychologically stick to their debt paying goals:
1. Debt Avalanche: This is the mathematically sound method. Rank all your debts by interest rate with the debt with the highest interest rate listed first and the lowest interest rate listed last. Take this hypothetical example:
In a debt avalanche, pay the minimums for all debts, and allocate any additional money to the debt with the highest interest rate. Once that debt is paid, move on to the second-highest interest rate until all your debts are paid.
2. Debt Snowball: This is the method to use to foster psychological investment in your debt payment. Rank all your debts by the loan amount with the smallest balance first and the highest balance last. Using the same hypothetical example as above:
For the debt snowball, pay the minimums for all debts, and allocate any additional money to the smallest debt until it is gone, then move to the second smallest. The logic behind this method is that the early successes keep you paying debt until you gain the momentum to pay the largest debts (like a snowball rolling down a hill and getting larger).
We have a strong opinion on this one, which probably stems from our prior experience teaching math. Paying off a student loan with a 5% interest rate before a credit card debt with a 15% interest rate is too devoid of logic for us to recommend to anyone.
Try the avalanche method unless you have a long history of losing motivation when it comes to paying off debt. If you have a short history of veering off course, there may still be tools to help you succeed at the avalanche method: Automate a payment larger than the minimum for the loan with the largest interest rate. Rather than relying on motivation, which ebbs at sporadic moments, just make it easy. In Atomic Habits, James Clear notes that a key to sticking to a habit is to make it easy. His advice is extremely applicable to financial goals since so many tools exist to automate your decision-making.
Debt Consolidation
If you have many debts, it may be worth consolidating them. Consolidating debts provides the convenience of submitting regular payments to just one location rather than tracking the minimum payments of multiple debts. The even larger potential benefit is obtaining a lower interest rate on your loans overall. This is not always possible, but it is worth exploring, particularly if you have high-interest loans from debts like credit cards.
A common way to consolidate debt is to apply for a fixed-rate debt consolidation loan. After receiving the loan, use it to pay off your debts in various locations, then pay back the loan with routine payments. Other methods include opening a transfer balance credit card with a 0% introductory interest rate, particularly if you can pay off your debt in a short period of time before the introductory period expires. Depending on your assets, 401(k) loans or home equity lines of credit are also options, but carefully assess the terms and conditions for these alternatives, as well as how they affect your financial situation.
The Five Debt Planning Points
If you are starting or in the middle of a long debt payoff journey, here are a few takeaways to guide your actions and expedite getting out of debt:
Always pay the minimums for your debts. Even if they are debts worth paying slowly, pay the minimums to raise your credit score or keep it high.
If you should be paying your debts quickly, pay as much as you can. Ideally, pay more than the minimum, and use the avalanche method if you have multiple debts.
If you pay more than the minimum, specify that any extra amounts should go towards the principal. This will cut down the time to pay off your loan. Do not let those extra dollars just go to interest payments!
If you get unexpected cash, commit to putting it towards any loans you should pay quickly. This includes end-of-year bonuses, gifts, inheritances, or anything else. Again, apply that extra amount towards the principal.
Make your plan non-negotiable. Set up automatic transfers that exceed the minimum payment required. Do not change them unless you are increasing the amount of money going towards the debt or the debt is gone.
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