Most of us have been told that when it comes to debt, it’s best to avoid it altogether You’ve heard it everywhere: Aside from a major purchase, like a home, if you can’t pay cash for something, then you can’t afford it.
Of course, that’s easier said than done. Consumer debt rose to $4.05 trillion in February, according to the Federal Reserve. And it’s not that all debt is bad. Used correctly, debt allows us to buy homes, pay for college and finance other needs, including unexpected medical bills.
But too much debt can become overwhelming. In fact, almost a quarter of Americans (23%) say their debt is greater than their retirement savings, according to a recent Harris Poll survey conducted on behalf of Prudential Financial. And 49% of Americans cite reducing or paying off credit card debt as a financial goal, but only 28% are confident they can do it, says Prudential’s 2018 Financial Wellness Census.
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Consumers can take heart. The truth is, it’s possible to pay down some of the most common debt and build retirement and emergency savings at the same time. But where do you start? Here are a few tried and true strategies for long-term debt management.
1. Begin by taking a step back.
Tally up your total and set realistic goals as part of an overall household budget. Researchers at Northwestern University found that small victories help win the war against debt, so setting reasonable goals likely provides the best path toward true debt reduction.
One small goal could be to follow the 50/30/20 rule. That is, spend 50% on household essentials, 20% on increasing savings and paying down debt, and 30% on discretionary purposes. There’s no one-size-fits-all solution, though, and a financial professional can help tailor a plan that fits your particular financial wellness journey.
2. Determine which debt to pay off when.
The rule of thumb is to tackle paying off your highest interest debt first, so it helps to understand some of the major types of debt and how to tackle each.
Credit card debt: With the average credit card interest rate hovering around 15%, credit card debt often carries the highest interest rates among types of consumer debt. It makes sense to aggressively attack your credit card balances — beginning with those that have the highest interest rates. The avalanche method — making minimum payments on all your cards while using any funds left over to pay off the highest-interest debt — works for many people.
Alternatively, for those who really need some quick wins to stay motivated, you can use the snowball method. You still make minimum payments on all of your credit cards, and then use what you have left over to pay off the smallest balances first to clear them off the books entirely. This method may keep you motivated, though you may end up paying more in interest over time.
Student loan debt: Interest rates for federally backed student loans range from 4.5% to over 7%, while rates from private lenders can be as high as 13% to 14%. With such a broad range, the best course of action to pay off student debt depends on your specific situation.
For example, for student loan interest rates of 6% or more, it is important to remember that some people qualify for a tax deduction of up to $2,500 for interest on a loan. If you qualify, that deduction can be churned back into emergency and retirement savings, or even put toward other kinds of debt.
When it comes to private loans, it may make sense — depending on the interest rate — to consider refinancing to a lower rate. Always seek professional financial advice before signing a new loan agreement.
Mortgage debt: With 30-year fixed mortgage rates near historic lows — averaging 3.82% as of mid-June 2019, according to Freddie Mac — you may think differently today about how to tackle this type of debt than in the past. Having a mortgage and making on-time payments builds your credit, which is one reason mortgage debt is often considered “good” debt and can be a cornerstone for financial achievement if handled responsibly.
3. Don’t forget to prioritize savings as well.
Even as you focus on paying down debts, it’s important to balance this against funding both emergency savings and retirement accounts at the same time. Many financial professionals estimate that people may earn an average of 6% to 8% on retirement savings over the long term. When evaluating strategies to pay down lower interest rate debt, such as a student loan, you may see a better bang for the buck by keeping up to date with the minimum loan payments and putting aside any extra toward retirement savings — rather than giving in to the natural tendency to pay off the loan first.
Similarly, historically low mortgage interest rates mean it likely makes sense to max out retirement savings before adding extra payments to home debt. Contributing toward retirement will likely do more for your long-term financial security than paying off your home early — provided you pay your mortgage off before you retire.
When it comes to creating an emergency savings fund or saving for retirement, consider what works best to help you achieve your goals. You can get out of debt without being too aggressive, allowing you to save money at the same time.
Just as it’s important to set realistic goals, it’s also important to avoid scrimping and saving to the point that you feel so deprived that you fall back into old spending habits. Enjoy an occasional night out. Splurge on something special. Leave room for some indulgences that help you stay the course.
If you need help sorting it out, many financial professionals will offer free consultations and share advice on how you can build a debt-reduction plan.
Once you have debt under control, you can embrace the FIRE movement, a philosophy gaining popularity particularly among millennials in recent years. FIRE stands for “Financial Independence, Retire Early.” That approach focuses on maximizing savings by finding ways to increase income or decrease expenses. Regardless of your motivation, lowering and paying off debt is always a good idea.
This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.
