Today’s discussion is regarding the different types of debt one has and strategies to use to pay them off. Before we dive into the classification of debt, one should consider the consequences of paying off all of their “good debt.” It may not be a good idea, because you could potentially be hurting your overall tax write-offs afforded to most real estate owners and losing time from simultaneously investing in the stock market, earning an annual return averaging around 7%. Resulting in a potential loss of future earnings, because you’re choosing to invest in paying down a debt that costs 3% instead of earning 7%, which could net you around 4% annually (7% - 3% = 4%). Remember, not all debt is created equal. We look at debt and classify them into good, intermediate and bad categories.
Good Debt: Under 5%
Example: Most of this debt is originated from your mortgage, which is usually amortized over a period of 15 to 30 years.
Intermediate Debt: 6% - 10%
Example: Personal loans or certain lines of credit, Home Equity Line of Credit, HELOC, will charge these types of interest rates, due to the lending institutions view of the borrower.
Bad Debt: Over 10%
Example: Credit cards are the main source of bad debt and, if not paid immediately, could cause the borrower hundreds if not thousands of dollars over the lifetime of the loan.
We look at debt and classify them into good, intermediate and bad categories.
Debt Repayment Strategies:
Always make minimum payments on all debts, especially “Bad Debt”, then follow the steps below, choosing a strategy that best fits your financial situation.
Step 1: Calculate your total debt and the interest rate for each one.
Step 2 A: The “Snowball Effect” - This repayment strategy works by targeting the account with the smallest balance first, then after completing the final payment redirect your funds, to the second largest balance. This method helps psychologically, because you are seeing progress of paying down debt in an expeditious manner.
Step 2 B: The “Highest Interest Rate” - This strategy works by targeting the account with the highest interest rate. In effect, your are maintaining minimum payments on all other debts, but focusing your efforts on the account that cost you more over time. Once you have repaid the debt on that account, move to the the account with the second highest interest rate. This strategy may feel, psychologically, that you have multiple projects going at once and making only little progress, but you are saving money by paying down the accounts that are charging you more interest.
Step 2A: Targeting the account with the smallest balance first or Step 2B: Targeting the accounts with the highest interest rates.
Alternatives: Debt Consolidation (Lower your interest rate below the credit card rates)
401k Loan - This option works well, because once the loan is taken from the 401k you will automatically make payments towards the loan. Also, the interest paid is credited to your 401k, not a financial institution. (Interest Rates: 5% - 7%, Length of Loan: usually 5 -10 yrs)
Home Equity Loan - Money borrowed against your home to pay off your high interest debt. Todays interest rates are near an all time low, if possible take advantage. (Interest Rates: 3% - 5%, Length of Loan: 5, 10, or 15 yrs)
Loan forgiveness or cancellation usually happens for student loan debt that is guaranteed in some way by the federal government, such as Direct Loans. There are many loan forgiveness programs that are for specific jobs, such as teachers and nurses. But we will discuss the most common options for the majority of borrowers: the Income Based Repayment Plan Loan Forgiveness and the Public Student Loan Forgiveness.
Income Based Repayment Plan Loan Forgiveness
This is available to any person with Direct Loans. Formally called the Revised Pay As You Earn Repayment Plans, payments under the plan options generally only make up 10% of discretionary income. Any outstanding balance after 20 years for undergraduate work or 25 years for graduate work will be forgiven. Keep in mind that you may have to pay federal income taxes on any amount forgiven at the end of the loan.
Public Student Loan Forgiveness
This is available to any government employee and some nonprofits. Under this forgiveness program, qualified individuals who work full time and are under an income driven repayment plan, can have their remaining loan balance forgiven after 120 qualifying monthly payments. You are required to submit a form periodically to certify that you have made qualifying payments while employed at a qualified employer. You generally also have to be employed at a qualified employer at the time of the application for forgiveness as well as when forgiveness is granted. Unlike other forgiveness options, the remaining balance is not subject to federal income taxes.
Loan forgiveness or cancellation usually happens for student loan debt that is guaranteed in some way by the federal government, such as Direct Loans.
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George A. Hinojosa & John Chan, MBA, CFP®
Partners at Independence Wealth Group (IWG)
Disclosures: This article is for educational purposes only and doesn’t reflect any particular advice. Prior to making any financial decision you should speak to a financial professional.
Securities offered through Interactive Brokers and TD Ameritrade., Member FINRA/SIPC. Advisory Services provided by GH Wealth Management, a Texas Registered Investment Advisory Firm. Insurance Services offered by Alamo Insurance and Wealth Management.
Risk Disclosure: Investing involves risk including the potential loss of principal. No investment strategy can guarantee a profit or protect against loss in periods of declining values. Past performance does not guarantee future results.