No matter who you are, you probably have debts. Sometimes they are just small debts which can be paid straight away, and other times they are massive, taking decades to shake off. But ask yourself the question, what should I pay off first?
Let’s say you have 3 debts to pay off. The first is a student loan, around $30,000. The second is some personal debt, let’s just say you bought some appliances and an expensive night out, $10,000. Finally you have a home loan of $500,000. All up you have debt to the tune of $540,000. With all of these you have regular repayments to make, and it takes up around a third of your income.
Just say you had saved $10,000, how much would you spend on this debt? What debt would you look at paying first?
Most would be correct in saying that personal debt should be the first thing to be paid off. Personal debts are often accumulated on high interest mediums like credit cards, so being able to quickly remove that debt to avoid interest is extremely important. Longer term debts like student loans and home loans are not as important over the short term as interest charged is relatively low in comparison to personal debt.
That of course isn’t to say you should just meet repayments for those long term loans. Whenever possible, pay down those loans. Chipping off as much as you can whenever you can. You’ll find over the long term you save a fortune in interest.
Speaking of, interest rates and the dollar figure of a loan are vital in determining what to pay off first. Things like student loans have low rates of interest, being set in line with the consumer price index (CPI). Home loans are slightly higher, but not by a massive amount. The only real difference for home loans are that the sums are significantly higher, meaning there is more to charge interest on.
Let’s take the example from the start, where all interest is just simple interest (being a consistent interest rate over a year long time period).
If you have a student loan of $30,000 and are charged 3% interest a year, you are charged $900 of interest. Compare this to a home loan, $500,000 at 4% becomes $20,000 in interest. In this case it makes much more sense to meet your minimum repayments for the student loan and cut off as big a chunk as possible on the home loan. Now if we bring in the personal debt figure from before, $10,000 at 15%, we see interest of $1500! As we said before, it makes sense to pay off that personal debt first.
Going off the same assumptions as above, if you put that $10,000 savings into your home loan, you would save $400 in interest. If you put it into your student loan you would only save $300. In the real world interest is typically compounded, not simple, but the same methods apply. Sit down with your loan amounts and figure out the differences you would be saving by putting money into paying off those debts. You might be surprised by what you find.
If you need help figuring out what loans to pay off first, be sure to have a look over the McCarthy Money My Money Coach!