I recently received this email from an accountant:
"As folks have some concerns about recession, I’m seeing a trend of clients focusing on paying off debt rather than taking out more debt for asset (usually real estate) acquisition. The same question always comes up – “which debt should I pay off first?” How do you advise people on prioritizing debt payoffs?"
I LOVE questions like this because there's no easy answer, forcing us to dig deeper than the financial facts into our personal values around money. To answer this question, ask yourself these questions.
Why do you want to pay down your debt?
Which debt you should focus on paying down depends on WHY you want to pay it down. Here are some potential reasons:
1. To save money on interest. 🤑
This makes particular sense when it's a high interest debt, such as a credit card. If this is your why, start with your highest interest rate debt. This may be the easiest to quantify as far as the math goes.
2. To free up your cash flow.💸
You may be frustrated by the portion of your income that's going toward debt payments and want to free it up for other uses. Getting serious about reducing your expenses and and applying extra income towards paying down your debt can free up your future cash flow for self care, vacations, real estate investing- you name it! (If you want to read a little about how my husband and I paid down our student loans, you can read this blog) If this is your why, look at debt with the highest payments and debt with low balances that could be paid off more quickly.
3. To qualify for new debt. 🏡
Prime examples could be buying a home or taking out a business loan. Lenders will look at your "debt to income" ratio as well as your assets and liabilities (what you own and what you owe) to determine how much debt you qualify for and at what interest rate. The example I shared in the referenced blog post above of paying off our student loa were what qualified us to buy our home. We still *barely* qualified, so those loans could have been a dealbreaker.
If you're thinking about buying a home, consult with a mortgage lender before making any decisions. There may be some fine tuning around building up savings, increasing income, paying down debt, and improving your credit score, to help you qualify for the best loan possible.
4. To feel debt free. 🥳
It's impossible to quantify the peace you feel when you become debt free. Never have I ever heard anyone say "Dang, I sure miss making loan payments". Usually they describe it as a weight being lifted off their shoulders.
While it's great to feel good about being debt free, make sure you're not making a decision in a vacuum, only focusing on one piece of your financial picture. Two common mistakes I see around paying off debt are failing to save for retirement and maybe losing an employer match, or liquidating a long-term investment to pay off debt and maybe incurring unnecessary taxes and missing out on long-term growth potential.
If you'd like to connect with someone who can guide you through making a confident financial decision in light of both the financial facts and your unique personal situation, please schedule a a free consult! 😁
PS If you're making decisions that involve paying off student loans, be sure to look into whether you may be eligible for loan forgiveness.
PPS Keep in mind that the greatest superpower in paying off your debt is to increase your income. 💰 💰 💰