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Just the thought of paying down debt can be intimidating and often discouraging for many.
Yet, 77% of American households have at least 1 type of debt.
If you are part of the 77%, you might be wondering what to do with your paycheck: Should you save your money and invest it, OR should you pay off your debt?
To answer this question, it’s essential to understand the pros and cons of either scenario and to understand your current financial situation.
In this guide, I will show you exactly how you can analyze the type of debt you have and when it could make more sense to save and invest over paying off debt.
Let’s dive right in.
Types of Debt
Before you determine whether it makes sense to save now or pay down your debt, you need to know which type of debt you carry.
In general, there are 2 main types of debt:
- Bad debt
- Smart debt
If you do decide to prioritize your debt when structuring your debt versus saving/investing profile, below are some of the pros that come along with paying off debt:
- Improves your credit score
- Gives you peace of mind
- Reduces the total amount of money spend on interest over time
It’s important to review your net worth statement and understand which type of debt (if any) that you carry.
1. Bad Debt
The first type of debt, also called bad debt, is the type of debt that you don’t want to have.
Some examples of bad debt include:
- Car loans
- Credit cards
- Payday loans
- Loan shark deals
Bad debt typically refers to high interest debt (higher than 10%) that you’ll find on credit cards, for instance.
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Bad debt also refers to any debt held on depreciating assets – like most cars, for example.
In fact, if you have bad debt, then you’ll probably want to prepare a solid plan to pay that down fast.
Most financial experts will advise you to pay off this high interest debt before you pursue any other financial goals.
Here’s how to understand how much and the type of bad debt you have:
- Review all of your current, outstanding debt
- Take note of any debt with interest rates above 10%
- Create an Excel spreadsheet, with columns listing debt type, debt amount, and interest rates
Once you’ve created this Excel spreadsheet, your next step will be to carefully go through your bad debt and input the data in your spreadsheet.
After you’ve sorted through your data, find out which debt has the highest interest rate.
Next, start paying off the debt with the highest interest rate first.
To accomplish this step, you’ll really want to cut out all “excess” expenses in your budget (like eating out, shopping for clothing, etc.) and use this “saved” money toward your high interest debt payments.
It might not be fun right now, but it will be worth the effort in the long run, when you achieve financial independence.
2. Smart Debt
Smart debt, on the other hand, refers to a type of debt that is low interest by nature (less than a 10% interest rate) and used for appreciating assets like real estate.
Below are some additional examples of smart debt:
- Some student loans
- Debt for your business
Smart debt is typically a type of debt that doesn’t need to be paid off ASAP.
If you’ve reviewed your net worth statement and feel like your debt is relatively manageable due to low interest rates and is used for appreciating assets, then it might actually be the right time to:
- Continue paying the minimum required payment and
- Start saving and investing your remaining money
The earlier you start saving and investing for your future, the faster you’ll achieve your financial goals.
3. Tax-Deductible Debt
I did want to spend a little bit of time discussing tax-deductible debt, which is essentially another type of “smart” debt.
Some examples of tax-deductible debt include:
- Student loans
- Mortgage loans
- Some business expenses
Many student loans, for example, are actually tax deductible.
In fact, depending on your income, you could deduct up to $2,500 in annual interest payments when you file your tax return.
For mortgage loans, you can deduct interest paid on the first $750,000 of mortgage debt.
And while business loan repayments are generally not tax deductible, the items bought with the loan could be deducted on your tax return.
Of course, it’s important to have these conversations with your accountant first to better understand how each loan can impact your overall tax strategy.
If you do find yourself carrying a tax deductible loan with a reasonable interest rate, then you may want to consider simply paying the minimum and investing the remainder of the cash instead of paying off the loan as fast as possible.
Your Emergency Savings Fund
While paying down bad debt is extremely critical for your future financial well-being, it’s also important to ensure you have a “rainy day fund,” or what experts call an emergency savings fund.
An emergency savings fund is a liquid cash account designed to be used for emergency expenses only.
Emergency expenses could include anything along the lines of:
- Vet expenses
- Roof repair bills
- Medical expenses
- Unexpected car bills
Emergency savings funds can also be used to help pay through an unexpected job layoff, for instance.
The sole purpose of an emergency savings fund is to prevent you from building more bad debt (through credit cards, for instance).
So, before you begin paying down any sort of debt, it might be a good idea to first set up an emergency savings fund using either a separate checking or savings account.
To get the biggest bang for your buck, you might even want to consider opening an online high yield savings account, which typically offers an annual percentage rate (APR) yield 500x higher than traditional savings accounts.
A general rule is to fund your emergency savings account with 3 to 6 months’ worth of living expenses.
Here are some examples of when funding the account with 3 months’ worth of living expenses might be enough:
- You are single
- You have a relatively stable job
- You’re in pretty good physical shape (no health issues)
However, if you can relate to the following scenarios, then you may want to consider funding your emergency savings account with 6 months’ worth of living expenses:
- You have kids
- You have an unstable job
- You expect many future health concerns
- You are the sole breadwinner in your family
If you are someone who wants to be prepared for every curveball that life will inevitably throw your way, then you may want to first build an emergency savings fund before aggressively paying down debt.
What if I Only have Smart Debt?
If you’ve reviewed your net worth statement and found that you’re only left with smart debt – then first of all, congratulations!
You’re already in a really good place.
With smart debt, you may want to structure your debt pay-off strategy a little differently.
In fact, instead of throwing every last penny toward your smart debt, you may want to consider just:
- Making the minimum required payments
- Investing your remaining cash into the stock market or other appreciating assets
Think about it this way:
If your mortgage interest rate is 3% and the average return in the stock market over the past 50 years has been around 7%, then you should probably invest your excess cash into the stock market instead of paying off your mortgage faster.
If you pay off your mortgage, you “earn” 3% (because you’re no longer paying the interest).
However, if you invest in the stock market (and stay invested for the long term), then you could earn 7% (or more) over the long run – which is the better deal of the two.
In fact, one of the first places you should consider investing your extra cash should be your 401(k) plan – especially if your employer offers you a matching contribution.
A matching contribution is like free money.
So for example, if your employer offers to match 100% percent on the first 3% of your contributions, then you’ll want to contribute at least 3% of your paycheck into your 401(k).
Deferring more into your 401(k) plan, of course, would be even better.
If you’re extremely proficient in investing, and you’ve already taken advantage of your employer matching contribution, then you may also want to consider other investment vehicles like alternative asset classes such as real estate or funding small businesses.
By prioritizing saving and investing first over paying off your smart debt, you can take advantage of compounding interest to ultimately work faster toward your financial goals.
Ultimately, there is no right or wrong answer on how you should plan to approach your debt pay down strategy.
The key is to diagnose your debt picture and determine which type of debt (smart versus bad) you have, if any.
If you do have debt, then smart debt and tax deductible debt will typically be lower risk, which means you can use extra cash to invest and save, instead of paying down those debts.
However, if you have bad debt, with higher interest, you may want to consider paying this debt down more aggressively.
Whether you decide to save and invest over paying down your debt is really a personal choice and comes down to your personal financial situation.
Just remember: The earlier you take action, the better off you’ll be financially.
Your bank accounts will thank you later.
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