If you watch any of the money guru’s on TV or listen to any radio shows, this is the number 1 question people ask. I get this question all the time, and people always expect a quick, easy answer. It’s not a hard question to answer, but it’s not a quick, easy question either.
To make the best decision, you first have to know what kinds of debts you have; and I do not mean good debt and bad debt.
Fixed Loans vs. Revolving Debt
The primary difference between debts is if they are fixed loans or revolving debt. Revolving debt, like a credit card, has a revolving balance. In my mind, they are like the revolving doors in old department stores. As you’re going in, someone else is going out.
Likewise, with revolving debt you pay something off, then charge the balance back up. As your payment drives the balance down, your new purchases drive the balance back up.
Fixed loans, on the other hand, do not allow you to continue borrowing. Once you make the payment, the balance goes down, and you cannot access that money again. A good example of fixed loans is car loans or mortgages.
This factor should be a big part of your financial plan when it comes to paying down debt or investing.
Another critical factor is the interest rate. Revolving debt, credit cards, tend to have high-interest rates. Fixed loans can sometimes have very low-interest rates. Though sometimes they are incredibly high also.
It is not a good idea to pay high interest for a long time, but if you can get a low-interest rate and earn more in an investment or savings account, it may be worth it. More on that in a moment, though.
I generally break debt into four categories, high-interest revolving, high-interest fixed, low-interest revolving, and low-interest fixed.
It’s Not Just About the Debt
There are other factors in this decision; mainly how the decision will affect your financial planning. Two factors I always take into account are age and liquidity. Let’s talk about liquidity first.
Liquidity is a fancy term for the money; you can quickly access. If you had an emergency, you could get the cash in a day or two. Bank accounts are liquid, and investments are liquid. Home equity is not.
For good contrast, if you needed $10,000 from your home equity, you would have to apply for a loan, get approved and then you could have the money. This process may take 30-60 days. If you have the money in the bank, you can walk in and get the money.
The ability to get to your money quickly is liquidity, and in a pinch having liquidity can be very powerful. Sometimes, even more, important than being debt-free.
So, What Do I Do?
First, always pay off high-interest credit cards. If an emergency comes up, you will still have access to the money. There is no reason to pay 16, 20, 25% interest on a credit card balance when you have money sitting in a bank account.
You should even pay off low-interest credit card balances quickly. Again, in the worst-case scenario, you can use the credit card to pay for emergency expenses.
Fixed loans become a little more complicated. I prefer savings over paying off low-interest rate fixed loans like a car loan. Having the savings account creates flexibility that making extra payments does not.
If you have an emergency, you have the savings account to use. If you decide to pay off the loan, you have the savings account to pay the loan off.
The biggest reason I like savings over paying off fixed loans is as a safety net. Paying off a $5,000 balance on your car is fantastic, but having $5,000 in an emergency fund is safer. If you lose your job, would you rather have $300 less in expenses or would you rather have $5,000 to tap into during that period of unemployment? This safety is often well worth the 2%, 4%, or even 6% interest you are paying.
If the fixed loan is high interests, you should look to refinance into a lower, more manageable interest rate. If your credit is not good and you cannot find a better interest rate, paying down the loan is often a good alternative. Lowering your debt can help you improve your credit and get a better interest rate in the future. You have to decide what a “high” interest rate is for you.
When Will This Advice Not Work?
You are the biggest threat to the above advice. If you are unable to put money into savings or stop charging up your credit card balance, my advice will not work. Honestly, if you do not control your spending habits, no advice will work.
What About Dave Ramsey Saying We Should Always be Debt Free
I do agree with Dave. Debt is a killer, and being debt-free gives you freedom. That being said, I believe someone with more investments and savings than debt is essentially debt-free.
If you would like help creating a customized debt and savings plan, schedule a time to talk at https://calendly.com/saveforyourfamily/phone-call