Perspective on Debt: Introduction
Financial advisors often get questions about how to manage debt. Does it make sense to pay off a mortgage? If you have many loans and want to start paying extra, which loan should get paid off first? Is it better to buy a car with cash or take out a loan? Is it a good time to refinance? There’s lots of advice out there about how to answer each of these questions, but what if you’re trying to decide between many different options? Worse yet, even looking at any one of these questions, you will sometimes get contradictory advice! What’s a person to do?
As advisors, part of the challenge of addressing debt-related questions is that this goes well beyond pure financial considerations. There are behavioral factors as well as personal values to consider. Some of the issues involve managing uncertainty about future plans. Balancing all of this to come up with the best solution for a given person at a given time can be very tricky.
Therefore, I decided to write a series of articles on different debt management issues. Each will look at a specific situation or perspective. In this introductory part, we’ll assume that you have decided that you are going to use a lump sum of cash to pay off some debts and that there won’t be any other significant life changes for the foreseeable future. We’ll also assume that your only concern is maximizing your reduction in loan costs. Which one should you pay off first?
Financially speaking, you can get most of the way there with this simple answer: the one with the highest interest rate. However, there are some wrinkles to just listing out all of your loans and picking the one that has the highest interest on the statement.
The most common significant wrinkle is that interest on a few specific kinds of debts are deductible on your taxes:
- Debt on homes: If you itemize your deductions, mortgage interest (up to a $1,000,000 limit on the principal balance) is deductible, as is interest on home equity loans and lines of credit (up to a different $100,000 principal balance limit).
- Business debt: Business debt is generally deductible.
- Student loans: Student loan interest up to $2,500 is considered an income adjustment (often called an “above the line” deduction), which essentially means you can claim the deduction whether you itemize or not. However, there are phaseout limits for student debt deductibility based on your modified adjusted gross income, currently starting at $65,000 for single filers ($130,000 for a married couple filing jointly).
As a reminder: these informational guidelines have many intricacies and are easily subject to change, so you should always consult a qualified tax professional before making assumptions about the tax treatment of your debt payments.
If a given loan is deductible, then for basic comparison purposes, you can reduce the interest rate in proportion to your marginal tax rate. For example, if you have a loan with 4% interest that has fully deductible interest and you are in the 25% marginal tax bracket, then this is comparable to a loan with 3% interest where you cannot deduct the interest.
A less common wrinkle is that some loans assess a penalty for paying off the loan early. This is relatively common in subprime or commercial mortgages, but is unusual in most other common debts. If there is a penalty, the exact method of computing the prepayment penalty will be specified in the loan document. Once you have computed the penalty in accordance with the terms of the loan, then you can approximately compare this loan with others based on the combined interest and the prepayment penalty. Analyzing the precise effect of all the possible permutations of this effect is potentially a bit tricky, and beyond the scope of this article.
There is another potential wrinkle which is usually relatively insignificant: not all debts compound on the same schedule. This means that some debts add interest to their balance only once per year, while some do it quarterly, monthly, or even daily. For the same nominal interest rate, the more frequently the interest compounds, the greater the effective interest rate. This effect is small unless the nominal rate is itself very high; you can safely ignore it in most cases or simply use it as a “tiebreaker”. For example, given a loan with an 8% nominal interest rate, the difference between compounding annually and compounding monthly is 0.3%, and the difference between monthly and daily is less than 0.03%. There are calculators out there to compute this for you, and most spreadsheets also have a function for this.
Astute readers may have noticed that throughout this article, I’ve ignored the effect of precise timing of payments, amortization, or any number of factors which may be relevant. There are certainly ways to further optimize the comparisons and make them more accurate, but for the situations that we encounter most often, the above treatment covers what’s needed to decide what order to pay off loans. Some of those factors will appear in future articles when we address different debt-related questions.
Next time, we’ll talk about the same debt payoff question from a behavioral perspective.
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