In the United States, it is very common to carry debt. According to a survey conducted by Pew Charitable Trusts, about 80 percent of American households have some kind of debt. The most common form of debt is a mortgage, although many individuals also have other monthly liabilities. These may include unpaid credit card balances, car loans, and student loans.
Most people see debt as a necessity. After all, very few families can afford to pay for homes, education, and vehicles with cash. However, debt can seriously affect people’s financial security, especially as individuals get older and closer to retirement age.
Many individuals must decide whether they should pay off their debt or save for the future with the money left over after covering minimum monthly payments. The following criteria can help make this determination:
The Overriding Importance of Creating an Emergency Fund
Some financial experts suggest that individuals prioritize the creation of an emergency fund, even over paying off high-interest debt. An emergency fund helps ensure that people do not fall back into debt should an unexpected expense occur. Emergencies do happen and dealing with them using a credit card can create an endless cycle of debt that discourages individuals from working toward being debt-free.
In addition to added financial security, emergency funds provide protection against car repossession, home foreclosure, or having to delay seeking medical attention that could result in serious consequences for one’s health. Ideally, individuals have between three and six months of living expenses in an emergency fund before they start thinking about saving or paying off debt.
Deciding Whether to Pay off Debt or Invest for the Future
With an emergency fund created, individuals next need to consider the types of debt that they have. Not all debt is created equal and, in some cases, it makes sense to prioritize paying off certain loans more aggressively than others.
In general, paying off high-interest debt will actually produce bigger returns than investing the same amount. If the interest on a particular debt is higher than the returns likely to be earned from investing, paying off the debt is typically the best decision. A good estimate for returns in a money saved in a 401(k) is about 7 percent.
Currently, credit cards have an average interest rate of about 16 percent. Some people may have loans with a much higher interest rate. These debts need to be eliminated as quickly as possible. Debts may have an early repayment penalty that cuts into the interest savings, so it is important to take a close look at paperwork.
Several of the most common forms of debt actually have quite low interest rates. For example, 30-year mortgages have an average interest rate of 4.6 percent and federal student loans are around 4.5 percent. In addition, auto loans typically sit around 4.2 percent.
However, these are averages, so it is important that individuals understand their personal interest rates. In the case of an interest rate that is close to or lower than these values, it may make more sense to invest than to pay off the debt. Again, assuming about a 7-percent return on investments, individuals can make the most of their money by investing it.
The Complicating Factors in Making Financial Decisions
While these rules seem fairly simple and straightforward, individuals should also recognize that financial decisions are not always driven by logic. People should take the time to figure out what matters more to them.
Some households are motivated to be debt-free, and their excitement pushes them to live frugally. Others may want to retire early, so they are more likely to maximize the value of their earnings through investing. If personal motivation does not align with the numbers, some options exist.
For example, individuals may want to try converting high-interest debt to low-interest debt if they are mostly motivated to save for the future. Credit card balance transfers often come with great deals, although it is important to read the fine print. Additionally, home equity loans can be used to pay off high-interest debt. Individuals may also be able to qualify for a competitive personal loan.
Another complicating factor is taxes. Both investing and paying off debt can have important implications. People who invest in a 401(k) or a traditional IRA receive tax breaks for doing so. This could tip the scales further in favor of investing. However, the rules depend on how much individuals contribute as well as their age.
Also, individuals can sometimes deduct the mortgage interest that they pay from their taxes up to a certain amount. However, the recent increase in the value of the standard deduction may mean that fewer households qualify for the mortgage interest deduction.
Student loan interest can also be deducted up to a value of $2,500 provided that individuals meet a variety of criteria. These tax benefits encourage people to maintain their low-interest debts while investing their extra income in retirement accounts.