Which Debts Should I Pay Off First?

In an ideal world, nobody would carry credit card debt. However, in the real world, debt is very real. Whether debt was caused by reckless spending, an unexpected medical bill or a life event such a job loss or divorce, it is never too late to come out from under the dark cloud of debt.

When struggling with debt, many people become overwhelmed with their bills and do how to start paying them off. One of the first (and most scary steps) is to make a list of all debts, their current balance, interest rate and the minimum monthly payment. No special tools are required for this task: either paper and pencil or an Excel spreadsheet will do the trick, although a spreadsheet makes it easy to update the information in the future. Regardless of your approach, you should create a simple chart like this one:

There are two primary schools of thought on debt payoff and you should pick the one that will help you the most. You should do what works for you personality. With the “debt snowball” approach, you pay off your debts with the smallest balance first. But it is imperative that you’re still making at least the minimum payment on all of your other accounts.  Once you pay off your smallest debt, you can cross that off your list, which visually helps you see the progress you’re making and motivates you to do more. As you move down your list, you add the payment that you would have used with the previous debts to the next one. Hence the name of the “snowball” -- one payment snowballs into another.  

The second approach is to “interest rank” your debts by paying off the debt with the highest interest rate first, since that debt is the one costing you the most money. As before, it is imperative that you’re still making at least the minimum payment on all of your other accounts. Once you satisfied the debt you have chosen to pay off first, you can put that monthly payment towards the next bill to speed up paying off your next one.

The interest ranking approach will save you money in the long run. But it also means that you don’t necessarily get “small wins” along the way by paying off smaller debts (unless they also happen to be those with the highest interest rates). If you are really disciplined and committed to paying off your debts, interest ranking is the best approach. If you need some initial wins, start with the snowball approach and then shift over to interest ranking.

Either way, as you get out of debt, you will improve your credit score and financial standing and working toward your financial independence.

Kent Smetters

Kent Smetters is the Boettner Chair Professor at The Wharton School of the University of Pennsylvania, the Interim Faculty Director of the Penn Wharton Public Policy Initiative, and a Faculty Research Fellow at the NBER. He was the former Deputy Assistant Secretary of the U.S. Department of the Treasury, and he subsequently served as a member of the U.S. Congress’ bipartisan Blue Ribbon Advisory Panel on Dynamic Scoring. Kent holds bachelor degrees in Economics and Computer Science from The Ohio State University as well as an MA and PhD in Economics from Harvard University. He previously cofounded a national registered investment advisory firm that built a new technology platform, grew the firm to over 50 advisors and then sold the firm to a large, publicly-traded company. Growing up in a financially poor family, Kent donates his time to “Your Money” to help families work, save and set goals in order to achieve the most in life. Kent is often cited in major news outlets.

Should I Refinance my Home?

With interest rates at historic lows, many homeowners are choosing to refinance to lower their interest rate. Lowering your interest rate will help you save money on your loan, lower your payments and possibly allow you to pay off your debt sooner. You can use an online calculator  to see your possible savings. However, refinancing your mortgage is not as clear cut as the TV advertisements may make it sound.

While the allure of saving money on your loan may cause you to run to your nearest mortgage lender, it is important to remember that a refinance can be as stressful as the first time you applied for the initial mortgage on your home. In order to ensure the lowest interest rate, you want to make sure your credit score  is as high as possible. Secondly, when refinancing your loan, you will have to pay closing costs again, which can add up quickly and negate any savings. Out of pocket costs such as a home appraisal, lawyer fees and application fees soon may negate the savings of the lower interest rate.

Another reason that a homeowner may decide to refinance is to use the equity in their home to complete a large home project or to consolidate debt. This type of refinance is called a “cash-out” refinance because you take out more money than you owe on your home in order, leaving you with extra money in your pocket.  A “cash out” refinance is beneficial for those homeowners who are looking to complete a project that would add significant value to their home or to consolidate their other debts to pay them off faster with a lower interest rate.

But taking out extra money to do upgrade a home is risky, because you could end up owing more to the bank than your upgrade is worth. So you should be very confident of the project. If you use the extra money to pay off other debts, you could end up losing your house if you fail pay off your new, larger mortgage. In contrast, many states have homestead rules that protect some house equity from creditors for non-housing debt.

When sitting down to make the decision on whether or not a mortgage refinance is right for you, it is important to know the facts about both your current and future loan. A simple chart will make comparison simple. Factoring in the closing costs and the down payment required for the refinance is essential to see if refinance is worth it. Can you afford to put the money down? How much will you be saving on a monthly basis?

In many cases, a refinance does not cover the additional fees unless you plan to be in your house for several years. For example, if your new down payment and closing costs total $5,000, but you only save $100 in Monthly Payment, then you need to be in your office for at least another 50 months, just to recoup those fixed costs. But refinancing can be a money saver if done under the right conditions.

 

 

Kent Smetters

Kent Smetters is the Boettner Chair Professor at The Wharton School of the University of Pennsylvania, the Interim Faculty Director of the Penn Wharton Public Policy Initiative, and a Faculty Research Fellow at the NBER. He was the former Deputy Assistant Secretary of the U.S. Department of the Treasury, and he subsequently served as a member of the U.S. Congress’ bipartisan Blue Ribbon Advisory Panel on Dynamic Scoring. Kent holds bachelor degrees in Economics and Computer Science from The Ohio State University as well as an MA and PhD in Economics from Harvard University. He previously cofounded a national registered investment advisory firm that built a new technology platform, grew the firm to over 50 advisors and then sold the firm to a large, publicly-traded company. Growing up in a financially poor family, Kent donates his time to “Your Money” to help families work, save and set goals in order to achieve the most in life. Kent is often cited in major news outlets.

How Much House Can I Afford?

A home tends to be on the of the biggest investments made. So when you are wondering which home to buy, it is important to know how much you can afford. It is often said that you should buy a home that is no more than two and a half times your base annual salary. However, it is imperative that you don’t use that general rule without taking your financial and personal resources into account. Many people end up struggling to meet the financial demands of home ownership. But by doing some calculations in advance, you can be assured that your home will be a source of pleasure and memories and not a poor investment.

You can use one of the many calculators online to estimate what your mortgage payment would be each month. Some of the calculators (links are provided below) will tell you how much home you can afford based on your salary, while others will estimate what your monthly payment would be. Both of these numbers are totals that you need to be both familiar and comfortable with. It is important to remember to include your Personal Mortgage Insurance (if your down payment is less than 20%), which can add upwards of $250 to your monthly payment. You also need to include your insurance payment. Obtaining quotes from several insurance companies will give you an estimate on what your payment will be. While some people choose to pay their insurance twice a year, others opt to pay the premium on a monthly basis. Some mortgage companies will even add this into your payment for you.

Once you have your base payment, you will need to figure out what your taxes will be on the home you are looking to buy. Most home listings give you a general idea of what the taxes are, however it is extremely important to confirm that figure with the tax assessor. The tax figure may include exemptions or discounts that the previous owners qualified for that a new owner may not. Taxes are usually paid to the mortgage company and kept in an “escrow” account, the mortgage company then will pay the taxes on the property from that account. Once you have an accurate number for the annual taxes, you should divide that number by 12 (months) and add that to your monthly housing payment. It is also important to

Now that you have a general idea (remember that interest rates and credit scores may make your payment fluctuate), it it time to look at the rest of your budget. Listing your monthly payments and expenses, along with the estimated mortgage payment will help you visualize if you can, in fact, afford the home you are looking at. You want to be sure that the home you’re purchasing will still allow you to make your payments and meet other financial obligations that you have. Once you own your home, is important to create a home budget (link to previous article) to keep track of and stay on to your budget.

 

Kent Smetters

Kent Smetters is the Boettner Chair Professor at The Wharton School of the University of Pennsylvania, the Interim Faculty Director of the Penn Wharton Public Policy Initiative, and a Faculty Research Fellow at the NBER. He was the former Deputy Assistant Secretary of the U.S. Department of the Treasury, and he subsequently served as a member of the U.S. Congress’ bipartisan Blue Ribbon Advisory Panel on Dynamic Scoring. Kent holds bachelor degrees in Economics and Computer Science from The Ohio State University as well as an MA and PhD in Economics from Harvard University. He previously cofounded a national registered investment advisory firm that built a new technology platform, grew the firm to over 50 advisors and then sold the firm to a large, publicly-traded company. Growing up in a financially poor family, Kent donates his time to “Your Money” to help families work, save and set goals in order to achieve the most in life. Kent is often cited in major news outlets.

How Long Will It Take to Pay off a Debt or Loan

When you have a loan, whether new or old, it’s important to know when you will have it paid off, especially if you’re goal is to become debt free. Listing and analyzing your debts [link to article, “Which debts should i pay off first”?] will help you get a clear picture of your financial situation and create a realistic plan to get you out of debt sooner.

While loans like a mortgage give you a date in which your loan will be paid off, some debts like credit cards do not. In order to figure out the pay off date, you need to know your current balance, interest rate, and current payment amount. A calculator offered by Bankrate.com allows you to plug in these numbers to give you the year and date of your projected payoff. A more general calculator is offered here.

If you are making the minimum payment on a loan, you will often end up paying a significant amount of interest along the way. One way to lessen the amount of interest paid is to make payments larger than the minimum. See our other article [link to article, “Which debts should i pay off first”?] for some strategies to do this. Obviously, paying more than the minimum will change your payoff date. This calculator will allow you to see how adding extra money to your payment will change your last payment date.

Remember that paying off your high-interest debts sooner will also improve your credit score and free up some of your monthly cash flow so that you can save more. Knowing your payoff amounts and dates will help you create a realistic long term budget for yourself.

Kent Smetters

Kent Smetters is the Boettner Chair Professor at The Wharton School of the University of Pennsylvania, the Interim Faculty Director of the Penn Wharton Public Policy Initiative, and a Faculty Research Fellow at the NBER. He was the former Deputy Assistant Secretary of the U.S. Department of the Treasury, and he subsequently served as a member of the U.S. Congress’ bipartisan Blue Ribbon Advisory Panel on Dynamic Scoring. Kent holds bachelor degrees in Economics and Computer Science from The Ohio State University as well as an MA and PhD in Economics from Harvard University. He previously cofounded a national registered investment advisory firm that built a new technology platform, grew the firm to over 50 advisors and then sold the firm to a large, publicly-traded company. Growing up in a financially poor family, Kent donates his time to “Your Money” to help families work, save and set goals in order to achieve the most in life. Kent is often cited in major news outlets.

How Can I Consolidate Personal Debt?

When struggling with debt, one of the first steps to getting your finances in order is to make a list of the balances, monthly payments and interest rates for each of your debts. This step creates a visual picture that is overwhelming and shocking. In another article, we discuss strategies for paying down this debt with our existing cash flow [link to article, “Which debts should i pay off first?”]

It might also be tempting to consolidate your debt in an attempt to pay them off quicker and for less money. But, as with any major financial decision, debt consolidation requires that you make an educated decision that is best for you. Debt consolidation isn’t really helping you pay off your debt; it’s simply putting it all into one location, with one (hopefully lower) payment.

One option for homeowners who are interested in debt consolidation is to use a home equity line of credit to pay off personal loans, credit cards, or vehicle loans. With current low interest rates, this may seem like an appealing option. However, it is also risky, because your home is now collateral for the bills you’re paying off. If you fall into default on these payments, you could lose your home. Bankrate.com offers this calculator to help with deciding if using your home’s equity is worth it.

Borrowing from your 401(k) is also another tempting option. However, even if your 401(k) plan allows you to borrow, if you ever switch or lose your job, you typically must repay the entire loan within 30 to 60 days. You likely won’t have that money if you used it to pay off other debts. Moreover, it is challenging to replenish your 401(k) because the government caps how much you can contribute each year. So this type of borrowing risks your retirement.

Another option is a debt-consolidation loan, which is offered by most banks and some private companies. But this option frequently ends up being laden with fees and hidden costs that will end up costing you more in the long run. Relative to non-bank institutions, banks tend to have a lower interest rates and be more upfront with loan terms. Just as with any loan, you will be paying interest on the borrowed money and this loan will probably extend the repayment length of your debt.

If you have several credit cards to pay off, you might also be lured into transferring all of your credit cards to a single card with a lower interest rate. Credit card companies often advertise “zero- percent” interest rate balance transfers. These offers are meant to entice you. But in reality, to qualify for a zero percent rate, you have to have an excellent credit score, which probably means very little credit card debt in the first place. Moreover, these credit cards often have additional one-time charges that undo their value. Make sure to check the fine print.

While debt consolidation may seem like an easy way out of debt, it is simply a bandaid to a much larger problem. Just as it’s important to GET out of debt, it is just as important to develop a plan to STAY out of debt. Creating and sticking to a strict budget will help you avoid digging into a deeper hole of debt.

 

Kent Smetters

Kent Smetters is the Boettner Chair Professor at The Wharton School of the University of Pennsylvania, the Interim Faculty Director of the Penn Wharton Public Policy Initiative, and a Faculty Research Fellow at the NBER. He was the former Deputy Assistant Secretary of the U.S. Department of the Treasury, and he subsequently served as a member of the U.S. Congress’ bipartisan Blue Ribbon Advisory Panel on Dynamic Scoring. Kent holds bachelor degrees in Economics and Computer Science from The Ohio State University as well as an MA and PhD in Economics from Harvard University. He previously cofounded a national registered investment advisory firm that built a new technology platform, grew the firm to over 50 advisors and then sold the firm to a large, publicly-traded company. Growing up in a financially poor family, Kent donates his time to “Your Money” to help families work, save and set goals in order to achieve the most in life. Kent is often cited in major news outlets.

ARM vs. Fixed Rate Mortgages

When researching and shopping for a mortgage, one major factor is the interest rate of the loan. The interest is basically the percentage of the borrowed money you must pay each year on the outstanding balance in return for the bank allowing you to borrow the money. There are two types of mortgages: a fixed rate mortgage and an adjustable rate mortgage. Being a knowledgeable consumer will allow you to save money in the long run.

A fixed rate mortgage is one that comes with an interest rate that will remain the same throughout the life of the loan. This type of loan allows the homeowner to rest comfortably, knowing that their monthly payment will remain the same, regardless of any fluctuations in the economy that cause interest rates to rise. These mortgages are simple to understand. Also, with interest rates at historic lows, using a fixed rate mortgage to lock-in a rate ensures that you will have an “inflation hedge” since your house value may rise with inflation but your fixed payment does not. An online calculator can help you estimate the monthly payment.

An adjustable rate mortgage, otherwise known as an ARM, is a mortgage whose interest rate fluctuates based on the economy. Typically, ARMs are cheaper in the beginning, allowing people to purchase more expensive homes than they could with a fixed rate mortgage. But these mortgages adjust with interest rates, so your payment could rise or fall with interest rates. ARM mortgages are also difficult to understand and their terms are often confusing to an average homebuyer.

 Why might you choose an ARM despite the risks? If you’re only planning on staying in a home for less than five years, then an ARM would make sense because the first few years of the payment are less expensive. Plus, a short term stay in a home would mean that you would probably be moving before the interest rate adjusts. However, it’s important to calculate what your payment would be if interest rates rise sharply. Would you still be able to afford the payment with a significant increase? If you answered “no” to either question, then go with a fixed rate.

Kent Smetters

Kent Smetters is the Boettner Chair Professor at The Wharton School of the University of Pennsylvania, the Interim Faculty Director of the Penn Wharton Public Policy Initiative, and a Faculty Research Fellow at the NBER. He was the former Deputy Assistant Secretary of the U.S. Department of the Treasury, and he subsequently served as a member of the U.S. Congress’ bipartisan Blue Ribbon Advisory Panel on Dynamic Scoring. Kent holds bachelor degrees in Economics and Computer Science from The Ohio State University as well as an MA and PhD in Economics from Harvard University. He previously cofounded a national registered investment advisory firm that built a new technology platform, grew the firm to over 50 advisors and then sold the firm to a large, publicly-traded company. Growing up in a financially poor family, Kent donates his time to “Your Money” to help families work, save and set goals in order to achieve the most in life. Kent is often cited in major news outlets.