Whether it’s a home mortgage, a car loan, credit card debt, or student loan payments, a lot of our clients come to us with existing debt on their balance sheets. Debt can be a sensitive topic of discussion as there is often a strong emotional response. Some families are debt averse – wanting to pay down outstanding obligations aggressively, while others are more comfortable using debt to finance large purchases or to leverage portfolios.
We often get asked questions along the lines of “do I have too much debt/should I pay off my debt?” or “which debt obligation should I pay off first?” The answer, unsurprisingly, is that it depends on a few factors.
- The first, and perhaps most obvious, is whether you can afford to pay down your debt. You may already have a considerable balance in your savings account, but before being able to pay down debt, it is important to ensure you have an appropriately sized “emergency fund.” An emergency fund should be between three and six months worth of your necessary living expenses and should be available to you on short notice without fee or penalty. If the balance in your savings covers your short-term living expenses, paying down debt might be an appropriate strategy for you.
- The second factor in determining whether you should pay down debt is the interest rate on that debt. Current mortgage rates are about 3.5% – 4.0% APR which still very attractive relative to historical norms. Your car loan may be at a similar interest rate, or it could be at an introductory 0% financing amount. The decision about which debt to pay down revolves around which interest rate is higher, regardless of the balance of the loan. If you have credit card debt at 18%, student loan debt at 8%, the mortgage at 4% and the car loan at 0%, then my advice would be to pay off the credit card debt first, followed by the student loans. The mortgage and the car loan would be the cheapest money you have access to in this hypothetical example and should be paid off last.
- Another factor to consider is the tax deductibility of the interest. Mortgages and student loans may be tax deductible, while credit card debt and auto loans are generally not. So in a scenario where your mortgage and your car loan have the same interest rate (or the car loan is slightly cheaper), you should actually pay the car loan off first because you do not get a deduction on your taxes for that interest paid.
- Finally, the last factor to consider is the state of your balance sheet. If you have a $50,000 outstanding mortgage balance on your home worth $750,000, it is a very different conversation than if your home is worth $150,000. The total amount of debt relative to your total assets should help determine whether debt pay down is necessary or a luxury. A good rule of thumb is to calculate all of your debt service payments (mortgage, car, student loans, credit cards, etc.) and divide it by your yearly income. If that number exceeds 36%, you may have too much debt. If it is a luxury, consider your other financial goals first: Have you saved for retirement? Do you plan to help children or grandchildren pay college tuition? Have you put off a major repair on your home that you might need to make in the next few years? If none of those apply to you and your debt is reasonable, then pick the loan with the highest interest rate and pay that down first and continue working until you’re left with the loan with the lowest interest rate.