One of the most frequent questions I get is related to paying off debt.
The question usually goes something like this: should I pay off (insert loan here)? The type of loan can vary, but the principles that govern debt management are similar.
Like most financial questions, the short answer is almost always: It depends.
Many variables factor into answering this question. I always ask a few basic questions to see if paying off the debt makes financial sense.
The first question I ask is what the interest rate is.
Knowing the interest rate will often make the decision easy. If you are paying high-interest, it is usually better to pay off the loan. Credit cards can charge more than 20 percent interest. That type of debt should get paid off quickly.
Lower interest rate debt will be less of a priority.
I have recently seen auto loans charge no interest or only 1 or 2 percent. That is cheap money. Some home mortgage interest rates are now also very low. I have seen people lucky enough to get a mortgage below 3 percent.
The next question I will ask is where does the money come from?
If the money you are using to pay off the debt comes from investments, you will need to know more. What has been the average rate of return on the investment and can you expect to earn that over the long term?
If an investment is making 8 percent, it doesn’t make much sense to sell and pay off debt that charges a 3 percent interest rate.
Another important factor is whether the debt is tax- deductible.
Most mortgage debt is tax deductible as is most student loan interest and business loans. When interest is tax deductible take extra thought. Calculate how much money you are saving by getting the tax deduction.
The last question I will ask is if they can afford it.
Having enough money to pay a debt in full is different than being able to afford it. Many retirees are pension-rich and cash-poor.
That means they may have a good income stream, but don’t have a nest egg to drawn from for unexpected events. There are always unexpected events.
You should always have an emergency savings fund of at least three months of living expenses.
If paying off a debt means sacrificing your emergency reserve then I usually recommend keeping the debt.
It can be easy to justify keeping some debt. But even good debt can make some people feel uncomfortable.
Owning a mortgage-free home can bring a peace of mind that is priceless. If you view your home as a security blanket more than a potential investment, then you should probably work to pay off the mortgage.
Like always, don’t act rashly.
Weigh the pros and cons before making the decision.