Financial Education 102: Pay Down Your Debts

Debt isn’t necessarily a bad thing if you can use that money for a positive thing, however, it’s better to have less debt than more usually. First, let’s talk about interest rates. Higher is better when someone is paying you, lower is better when you are paying someone else. Unfortunately, people that don’t make much money or aren’t very good with their spending often get lured into these higher interest rate debts and loans. Often it’s a function of circumstance, and was unavoidable. 

The pay day loan industry is the perfect example of offering little loans at huge interest rates, even over 500% annual interest! That means that if you were loaned $100, and took a year to pay it back, you would pay $600! If you’re reading my blog, I doubt you have ever done a payday loan, but on the odd chance you have, pay that thing off!

Next up is credit card debt. Rates range from 6% to 25%, typically in the 20% range. So if you had $1000 in credit card debt and took a year to pay it down, would pay $200 interest on that money. A simpler way to think about it is, you go out for dinner and spend $30, which is not crazy for a single person especially if you have a couple drinks of alcohol. That meal could cost you $36 if you take your time paying it off. That’s $6, just for the privilege of paying with the credit card! If you’ve got credit card debt, pay it off. That stuff is expensive. 

Then we come to student loans. Ugh, student loans are tough because you it’s much harder to get rid of them, even if you declare bankruptcy they can follow you. These kind of depend on the interest rate. Personally I say if it’s over 7%, try to pay that off quick. If it’s lower, I had a couple at 2.8%, you can take your time paying them off, but rest assured, every day that you do not have loans accumulating interest is a day you are saving a little bit of money. 

Car loans are also super common type of debt people have. Car loans often come with really good interest rates, even 0% sometimes. However, vehicles are depreciating assets that lose around 15-20% of their value each year for the three to five years at least. In other words, that’s great that you just bought a mid-size car for $25,000 (with $0 down), and got a great 2% interest loan, so you are only paying $40 a month in interest, which is only 1.5-3 hours of work (after tax) a month. However, that car will only be worth something like $21,000 after one year. So you just paid $480 or so in interest for the year, plus you lost $4000 in value on the car. Point being, drive your car as long as you can stand to get inside of it, because they are not an investment, but a significant expense.

Finally, the mortgage. A mortgage is probably the best kind of debt. While student loans enable a high paying career, there is always the risk that something goes wrong and you or your loved ones are stuck with the loans, and nothing to show for them. A mortgage on the other hand includes a physical place, a piece of property. While it can flood, and it can burn down, it can’t really be stolen and it’s extremely rare for it to disappear (like in a sink hole or in a land slide). However, if you own less than 20% of your house, and you are paying Private Mortgage Insurance (PMI) every month, that is quite expensive and worth paying extra until the bank owns less than 80% of the value. Of course, there is nothing wrong with paying down the mortgage further, and at some point in the financial journey, it probably makes sense. Of all the types of debt this is the least concerning, so leave it for last.

In short, while it feels insurmountable, paying a little extra on your debt payments goes a long way toward saving you money on interest rates. The first time you pay off a debt, celebrate! It’s a big accomplishment and paying off debt and building the habits to stay away from debt are a lot harder than making money.