How to Pay Off Debt – and Save Too
Student loans, credit-card balances, car loans, and mortgages – oh, my. You probably have a variety of debt – most people do. So which should you focus on paying off first? And how can you save at the same time? Here’s a guide.
1. Set aside money for an emergency.
Losing your job – or being hit with an unexpected expense – could force you into a financial hole, which may take years to climb out of. How much to set aside for an emergency depends on your situation. In general, three to six months of expenses is a good starting point. If you are single, or in a family with two working spouses, three months may be enough. But if you are a one-income family, you may want to have six months of expenses.
Quick tip: Set up automatic payments from your paycheck or checking account into a separate account set up as an emergency fund.
2. Don’t pass up “free” money at work.
Paying down debt is important, but if your employer matches money you put into a 401(k) or 403(b), don’t pass it up. Think of it as “free” money. Let’s say your company matches 50 cents on every $1 you contribute, up to 3% of your salary. If you make $60,000 a year and contribute 3%, or $1,800, your company kicks in another $900. If you do that every year, in 10 years that $2,700 a year could grow to more than $37,000, assuming a hypothetical return of 7% per year.1
Quick tip: Give this money a chance to grow. If retirement is years away, that means leaning more toward stocks and stock mutual funds.
3. Pay this debt first: high interest credit card balances.
It can be easy to run up a large credit card balance. And once you do, it’s not easy to pay it off. The minimum payments are typically low, which means you are paying mostly interest, so it will take much longer to pay off the balance. And it will cost you more. So if you can, consider paying more than the minimum each month.
Avoid using a credit card to finance purchases. Why? In some cases, it could double the cost of the purchase. Say you buy a $2,000 flat screen TV on a credit card with a 15% interest rate. If you make only the $40 minimum monthly payment, it would take you more than 17 years to pay off the original debt. You would pay the lender more than $2,500 in interest-essentially doubling the cost of the TV.
On the other hand, if you are diligent about paying off your entire balance monthly, you may want to consider a cash-back rewards card. That way, your credit card purchases can actually help you accomplish other financial goals.
Quick tip: Check your credit card statement to see how long it will take you to pay off the balance-and how much it will cost you-if you make only the minimum payment.
4. Pay this debt next: private student loans.
Private student loans for college carry higher interest rates than government student loans, in general. Currently, rates on private student loans are from 5% to 12% compared with about 4% for government student loans, according to FinAid. You may be able to deduct the interest on a student loan, however, but only up to $2,500 a year, and only if you are a single filer earning less than $75,000. If you make more than that, you can’t deduct the interest. In general, it is a good idea to pay down student debt above 8% interest. This is especially true when this debt is not tax deductible.
5. Back to savings if you have a 401(k): Contribute beyond the employer match.
While you may still have a government student loan, car loan, or a mortgage, these loans typically have much lower interest rates. That’s why it can make sense to bump up your 401(k) contributions and continue to make payments on these loans.
Your savings can really add up. Using the same numbers from our example above, assume you contribute 10%, or $6,000 a year, about $115 a week, of your $60,000 salary to your 401(k), and your company adds $900. If you do that every year, in 10 years that $6,900 a year could grow to more than $95,000, assuming a hypothetical return of 7% per year.2
Also, a health savings account (HSA), can be a tax-efficient way to save and pay for both current and future qualified medical expenses, but not all employers offer one. Check with your human resource department.
6. Pay monthly minimum on government student loans, car loans, mortgages.
These loans have lower interest rates, and some offer tax benefits. That’s why it generally makes sense to make only the minimum monthly payments on them. For instance, mortgage interest is deductible for federal tax purposes, and rates have been at historical lows, right now around 4% for a 30-year fixed loan. Car loans are about 3%. Government undergraduate student loans are currently around 4%, and the interest may be tax deductible.
A word about student loan debt. Most college graduates have various types of debt-and various interest rates. Here are some general guidelines.
– Pay down: As we said earlier, it makes sense to pay off high interest debt (private student loans above 8% interest) first, especially if you cannot deduct the interest.
– Toss up: It may be beneficial to pay down medium interest rate debt, such as Direct PLUS and Direct Unsubsidized loans for graduate students, in certain situations and not others. Many factors can affect this decision, such as current and future tax rates, how comfortable you are with risk, and your goals.
– Pay monthly minimum: Low interest rate debt, such as Direct loans for undergraduates and Perkins loans, or medium interest rate debt (see above) that is tax deductible, does not need to be paid down early because of the tax benefits and low interest rates.
If you are disciplined about making payments, you may want to extend low-interest government student loans to lower your minimum payments and use the savings to pay down higher-interest rate loans faster. (The government allows you to consolidate and extend most government student loans at your current interest rate.) However, you may end up paying more interest because the time period is much longer. Contact your loan servicer for information.
Paying off debt is important. That’s why it makes sense to have a strategy that will help reduce what you pay in interest and increase your savings – giving it the potential to grow.
- Hypothetical growth of a yearly $2,700 contribution for 10 years at 7% year.
- Hypothetical growth of a yearly $6,900 contribution for 10 years at 7% year.