If you’ve been trying to dig yourself out of a debt hole, it’s time to take a break and look at the bigger picture.
Did you know there are often advantages to paying off certain types of debt before other types? What the simple list above doesn’t include is the average interest rates or any tax benefits to a given type of debt, which can change your priorities. Let’s check them out!
Credit card interest rates now average over 15 percent, and interest rates are on the rise.2 For most households, credit card debt is the place to start – stop spending on credit and start making extra payments whenever possible. Think of it as an investment in your future, one that pays a 15 percent guaranteed return – the equivalent of a 20 percent return in the stock market or other taxable investment.
Interest rates for auto loans are usually much lower than credit card debt, often under 5 percent on newer loans. Interest rates aren’t the only consideration for auto loans though. New cars depreciate nearly 20 percent in the first year. In years two and three, you can expect the value to drop another 15 percent each year. The moral of the story is that cars are a terrible investment but offer great utility. There’s also no tax benefit for auto loan interest. Eliminating debt as fast as possible on a rapidly depreciating asset is a sound decision.
Like auto loans, student loans are usually in the range of 5 percent to 10 percent interest. While interest rates are similar to car loans, student loan interest is often tax deductible, which can lower your effective rate. Auto loans can usually be paid off faster than student loan debt, allowing more cash flow to apply to student debt, investment accounts, or other needs.
In most cases, mortgage debt is the last type of debt to pay down. Mortgage rates are usually lower than the interest rates for credit card debt, auto loans, or student loans, and the interest is usually tax deductible. If mortgage debt keeps you awake at night, paying off other types of debt first will give you greater cash flow each month so you can begin paying down your mortgage.
When you’ve paid off your other debt and are ready to start tackling your mortgage, try paying bi-monthly (every two weeks). This simple strategy has the effect of adding one extra mortgage payment each year, reducing a 30-year loan term by several years. Because the payments are spread out instead of making one (large) 13th payment, it’s likely you won’t even notice the extra expense.
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