Wednesday, November 4, 2009

Get Smart About Debt - Rule #4

The fourth rule of "Get Smart About Debt" is to eliminate the right debts first. Specifically, you need a one-two punch. First, reduce your spending, and second, use the additional money saved to accelerate payment on the debt that has the highest interest rate. Typically, that's your credit cards. Once you've paid off your highest-rate loan, apply the money to the next-highest rate loan, and so on.

Frequently, you may want to exclude home or student loans from this process. Interest on these types of loans create a tax deduction for the borrower, and consequently, the real interest rate being paid on these loans is less than the amount simply being paid to the bank or the educational institution. To figure out the real interest rate on these loans, multiply the nominal interest rate by one minus your marginal tax bracket. For instance, the real interest rate on a 6% marginal home loan for an individual in the 25% tax bracket is:

6% x (1-.25) = 4.5%

Note that these payments create a tax deduction only if the tax payer is itemizing deductions. If only the standardized deduction is claimed, there is no additional tax benefit.

Accelerating payments on loan balances is extremely beneficial. Consider a $5,000 credit card balance with a 15% interest rate. An individual making a $100 monthly payment would take 6.6 years to pay off the loan, and cost $2,896 in interest payments. Meanwhile, if payments were increased to $150 a month, the loan would be paid off in 3.7 years and cost the borrower only $1,509 in interest payments.

Speak to an independent fee-only financial planner about putting together a schedule to eliminate your debts. The faster you eliminate your debt, the earlier you can begin to invest, and the better your retirement will be.

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