Many people have an unhealthy relationship with debt, especially credit card debt. Debt can keep you up at night, affect your home and work life, and make you feel like you’ll never get a handle on your finances.
Financial considerations of debt management and its emotional burden are two sides of the same coin. On the one hand, you want to know whether you should pay off your debt first before you start saving - or at least, that’s one of the most common questions we are asked. On the other hand, living with debt can undoubtedly be stressful.
The good news is, that you can manage your debt once you find the balance between the financial aspects and your emotional needs around debt management. Let’s talk about the different types of debt and considerations for paying it off so you can stay on top of your financial situation now and in the future.
Good Debt vs. Bad Debt — What’s the Difference?
Not all debt is created equal because not all interest rates, repayment options, and purpose of “being in the hole” are the same. Let’s take a look at good debt vs bad debt.
Credit Card Debt
Revolving debt — such as credit card debt — is considered bad debt because it’s costly and can affect your financial future.
For example, if your credit card has an interest rate of 20% and you owe $10,000 while paying the minimum monthly billed amount, this debt compounds as you’re probably only paying on the interest rate through your monthly payments vs. paying on the principal owed.
Generally speaking, you’ll want to pay off high-interest credit card debt quickly so you’re not spending months (or even years) paying extra interest (or worse, paying almost only interest).
Most people take out a mortgage when they purchase a home. However, a mortgage is amortized, or paid off over time, which means the loan has a set monthly payment during a certain time period, eventually leading you to pay off your mortgage in full. This is why in most cases mortgage debt is considered good debt. Plus you need a place to live, and why not pay to live in an appreciating asset?
The most common type of mortgage is a 30-year fixed mortgage. Your monthly payment is made up of a portion of your interest rate and your mortgage principal. In the early years of your repayment schedule, the majority of your payment goes towards interest. As time passes, your monthly payments start to go more towards the principal owed.
Working With Your Debt
When you have different kinds of debt, you have options for how to pay it off more effectively.
Pros and Cons of Refinancing A Mortgage
If mortgage rates drop after you obtain your mortgage you may consider refinancing. If prevailing interest rates are low enough that the benefit exceeds the costs of doing so, then this may be a good move for you.
However, any time you refinance, you’ll end up paying more in interest vs your mortgage principal, so it’s crucial to understand the balance and make sure you only refinance when it makes sense to do so.
Before you make any decisions, consult your financial advisor to understand why you want to refinance and whether it is right for your financial situation.
Reasons To Refinance Your Mortgage
If you are taking cash out to make improvements to your home that can enhance the value of this asset, then refinancing could make sense for you. But should you take money out of your home to pay off credit card debt? If mortgage interest rates are low enough, using a cash-out refinance to pay off credit card debt may make sense. For example, if interest rates are 3%-5% for refinancing your mortgage loan but are 18% or more for credit card debt, paying off the debt from your credit card(s) with the money from your cash-out refinance may be a good decision, provided you are committed to not accruing more credit card debt in the future.
In this way, your debt has moved from revolving debt to an amortized mortgage schedule at a much lower interest rate, which means you now have a healthier form of debt that can be paid off efficiently.
Paying Off Debt vs. Investing
In many cases, it may feel like you have to choose between paying off debt as opposed to putting extra money towards investing in your future. If you look strictly at the numbers, making a decision about paying off debt vs investing becomes a bit easier. It’s better to invest and put surplus money to work for you if you can get a greater annualized return on the investments relative to the cost of your debt
For example, if you have student loan debt with a 5% interest rate, you can continue making minimum payments and invest any surplus to get a return that is higher than the 5% interest payments.
Even if you are paying a 30-year mortgage off, investing surplus cash is often a better choice than paying off your house. However, on the emotional side, some people are uncomfortable with 30 years of debt repayment, which is why a conversation with a financial advisor can help.
A good advisor will show you the numbers and help you to see what the differences are in paying off your long-term debt versus making minimum payments and using the surplus cash for investment purposes. In some cases, a balance of paying off debt and investing is a good way to tackle the emotional side of debt management.
Financial Advice for Meeting in the Middle
It is indeed possible to satisfy your emotional needs around debt while still making investments to grow your future wealth.
The Bottom Line for Paying Off Debt
Whether it’s credit card debt or a 30-year mortgage, you have to have a conversation with yourself before you make your move.
Before paying off debt, you’ll want to remember:
- The higher the interest rate, the less likely you want to keep the debt.
- Whenever you’re making decisions about managing your debt, think about how (if at all) it will better your financial position to pay it off.
- Talk to a financial advisor to discover what works best for paying off debt in your unique situation.
If you’re ready to take control of your debt, Beck Bode is here to help. Schedule a Discovery Call today.