Deciding the best way to pay down debt
We overspent during the holidays but will be receiving a tax refund. Should we use our tax refund to pay down our debt?
Great question and this is the perfect time of year to take a closer look at finances. The holidays are a distant memory and taxes are out of the way. By now many have or will shortly receive any tax refund due to them. Before you decide how to use your tax return I would ask some questions to help determine the best plan of action.
Are you using a budget? If not, it’s likely that you are spending too much or even wasting your hard-earned money. A budget may prevent this pitfall. Money is a tool and like any tool it needs to be used properly. If you are careless with a hammer, you just might smash your thumb. The misuse of money can cause pain of a different nature but, with longer-term ramifications. Don’t let this be you.
Your budget will tell you how much money is coming in and how much is going out. You will have a deficit or a surplus. If you do not have a surplus then you must make adjustments. Spend less or earn more, but you must fix it.
How much money is in your emergency savings account? I ask this because you will want to have at least minimal emergency savings started before you start reducing your debt. For someone just starting to save for emergencies, the first goal is $1,000, then one month of living expenses and continue building that up to six months. If you don’t have this cushion you will add consumer debt when the first unexpected expense occurs. Remember to expect the unexpected.
What kind of debt do you have? I won’t say that there is good or bad debt but we can all agree that some debt is more detrimental to your finances. That which has higher interest rate charges and those purchases of assets which depreciate quickly is best to avoid. Credit cards, auto loans and debt consolidation loans are considered consumer debt and this is where many people get into trouble.
One can also incur debt for medical expenses which may be unavoidable. Perhaps you incurred a tax liability due in part to a lack of planning or some other unforeseen financial event. The mortgage on your home or other real property is a considered collateralized debt. We are still in a historically low interest rate environment for home mortgages and of course real property will appreciate over time.
Unless the tax laws change, you are still allowed to deduct the interest you pay on your mortgage from your taxable income and the proposed tax changes from the Trump administration still include this deduction. The interest which you pay on your consumer debt is not deductible from your taxable income. According to Bankrate.com the average interest charged for credit cards is 16.38 percent compared to the S& P which returned 11.96 percent in 2016. Do the math and we can agree that consumer debt is clearly more detrimental to you.
How much debt do you have and does your budget cover the necessary debt service? Debt service is the amount you are paying for the debt. For example, the minimum monthly payment on your credit card, or the monthly mortgage that you pay. If you are only paying the minimum on credit cards then the interest will likely grow that debt instead of your payments reducing it. If you can pay extra on your home mortgage then you may be able to pay it off early. Wouldn’t you prefer to be in the latter group?
Once you have addressed your budget and your emergency savings situation and the type of debt which you have, then you can make an educated decision if you should use your tax refund to pay down your debt, open a new investment account, fund your retirement account or go on a relaxing vacation. I am of the opinion that the interest which you are paying for consumer debt is worse for you, than the potential growth earned in an investment account might be beneficial to you.
There are different ways to deal with your debt. Some might switch credit card balances to a new card offering lower or zero introductory rates. Seems reasonable. Here is where this plan goes bad. Even though you are getting a better rate and possibly slowing the growth of your credit card debt, the new card will undoubtedly have a one-time fee of (X) percent. The same is true for consumer debt consolidation loans. With either of these strategies, you should chop up your credit cards because behavior is an issue. Otherwise you will end up with an additional debt to pay down and higher debt service making your cash flow even tighter.
Refinancing your mortgage and withdrawing equity to consolidate your debt into easierto-handle debt service is a possible option. This will indeed reduce the monthly payment for your debt service but it hasn’t reduced your debt. In fact it may stretch out the length of time it takes to pay down that debt. Again, behavior is an issue.
One approach is to pay off the debt with the highest interest rate first. You pay whatever extra you can find to pay off this debt first. Then pay down the debt with the next highest interest rate charged. This is fine if you can handle your current debt service and you are disciplined. This may save you quite a bit in interest charges over the life of the debt.
Another strategy and my personal favorite is the debt snowball. The Dave Ramsey fans out there will recognize this. Instead of focusing on the debt balance with the highest rate, focus on paying off the debt with the smallest balance first. Once that debt is gone add that payment amount to the next smallest balance. Let me give you an example.
Assume that you have three credit cards. One has a $500 balance with a $25 minimum monthly payment, another has $1,000 balance with a $50 minimum monthly payment and the third has a balance of $1,500 with a $100 minimum monthly payment. You pay $50 per month instead of $25 on the smallest balance of $500. You continue to pay the monthly minimum on the other credit cards. Once the $500 credit card is paid off completely, you add that $50 a month to the next smallest debt with the $1,000 balance. So now you are paying an additional $50 per month to the already minimum payment of $50 on the $1,000 balance. You continue paying $100 monthly until it is paid off. Once that balance is paid off, you add the $100 to already $100 minimum payment and begin paying $200 per month against the $1,500 balance.
In the above example, you are increasing your payment $25 per month to add to the smallest payment. Once you begin this process your payment against your debt stays the same at $200 per month. But you are paying a larger amount against each individual debt balance. Hence, the debt snowball. Paying off the smallest debt gives you victory early in your debt reduction pan. Don’t underestimate the psychological power of winning, even small wins.
Resources for credit counseling services: Consumer Credit Counseling Services credit.org/cccs; National Foundation for Credit Counseling nfcc.org; Christian Debt Counselors christiandebtcounselors.net; Money Management International moneymanagement.org.
Resources for budget tools: everydollar.com, mint.com, nerdwallet.com, gnucash.org, levelmoney.com is like an envelope system on your phone. Check with your bank and of course your financial advisor. All of our clients get access to an easy to use online budgeting tool and some actually use it! We even have envelope systems for those who prefer old school and don’t forget good ol’fashioned pen and paper.
As I stated a few times above, behavior matters. Why? Because none of the above will work if you do not change your behavior. We all need to live within our means and make changes if we are not. If only the government would do the same. Until we talk again, be well.
Dale Immekus is the owner of Dedicated Financial Services and an accredited wealth management advisor. If you have any questions for our panel of financial experts, email NewsSentinel Editor Scott Howell at scotth@lodinews.com or call 209-369-7035.