Thursday, 10 July 2014

Paying off debt? Remember that not all debt is created equal

Psychologically debt is a funny thing.  Most of us need it from time to time and debt is not always a bad thing.  In fact even consumer debt can sometimes be acceptable.  Your home loan is a form of consumer debt that most of us need to take out at some point in our life and this is fine.

Debt also needs to be paid back over time however many people do not pay back their debt in a logical manner.  There is an order that you should pay off your loans however many people do not pay off their loans in this way but rather spread their repayments equally over all their debt.

What is the logical order to repay debt?

Debt should always be paid back in the following order:
  1. Repay the highest interest non tax deductible debt first
  2. Repay other non tax deductible debt in order of interest rate from highest to lowest
  3. Repay tax deductible debt (assuming the after tax cost of this debt is lower than the lowest cost non tax deductible debt)
You should not pay the principal on any of the cheaper debt until the most expensive debt is completely paid off.  Of course you should continue to make the interest repayments and allocate the principal component of this debt to the higher cost debt.

Want an example?  Ok assume you have the following debts...what order should you pay them off?
  • A $300,000 home loan at 5% p.a.
  • B $10,000 credit card loan at 22% p.a.
  • C student loan of $20,000 which increases at CPI (inflation)
  • D $200,000 tax deductible investment property loan at 6% p.a.
You should pay the principal amounts off in the following order
  1. First pay the credit card loan off.  It is the highest cost by a mile.  You should pay only the minimum balance on everything else or convert them to interest only loans until this loan is paid off
  2. Then pay off your home loan - it has the next highest after tax cost.  Yes it has the biggest balance but it is also increasing at the fastest rate so you want to get on top of this as fast as you can
  3. Then pay off your investment property loan.  Assuming you are on a tax rate of 40%, the after tax cost of this loan is 3.6% 
  4. Then pay off your student loans.  Obviously it depends on the rate of inflation in your country but in Australia inflation typically runs at 2-3% so it is easily your cheapest cost of debt
Paying the loans in this order decreases the amount of time that it will take you to pay down your loan balances and reduce the total amount of interest you pay over time.  By targeting the highest cost of debt first you are being the smartest and most efficient with your repayments.

What are some of the reasons that people don't pay their debts in a logical order?

People rarely pay off their loans in the optimal order.  In fact I know very few people that would pay off their loans in the order I suggested above.  Why?  Here are some of the reasons I think people pay off their loans in a sub-optimal way:

People like to see whole debt balances gone so pay off their smallest loans first

Most of us feel better when we have less debts to deal with.  What this leads to is people striving to pay off their smallest debts first even those these debts may not be costing us a great deal.  I know a number of people who have paid off their extremely cheap student debt before they pay off their home loans which are costing them far more.

If you can ignore the 'feel good' feelings that comes with paying off whole balances and concentrate on paying off your debt in a logical manner you will be much better off financially.

People like to see their loan balances decreasing

The painful thing about making minimum repayments (which may actually increase the loan on some types of debt) or by paying interest only, is that your debt balance goes nowhere.  You are paying money towards these loans but your balances aren't going down at all.

People generally prefer to see their loan balances going down from paycheck to paycheck and it can be rather disconcerting to see most of the balances staying the same even though you are making payments. 

In this case what you need to concentrate on is the fact that you are actually paying down your highest cost of debt loan faster as a result of concentrating your payments.  You are paying less total interest tomorrow because you are getting rid of your highest cost of debt today.

People can't be bothered changing their payment plans

Most forms of debt come with a pre-arranged payment plan and it takes effort to change it and most people can't be bothered going to their bank and changing this.  

For example most people would have their home loans and investment loans set up so that their are paying both principal and interest.  If you wanted to pay down your credit card debt faster you would convert these loans to interest only loans and pay the extra amount off your credit card debt.  After your credit card debt was paid off you would convert your home loan debt back to principal and interest.

Doing this takes effort and there is one big trap - you end up with a whole lot more free cash which you can blow.  If you are sensible and committed you should use all of this extra cash to pay down your debts and after the highest cost debt is paid off use all that cash to pay off your next highest cost of debt.

Paying down your debt does have a logical order.  If you follow it you can really improve your financial situation and get your debts under control faster.

How do you pay down your debts?  Do you have a pre-defined order?  Have you ever done anything illogical to 'feel better'?

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