Debt Repayment 101

101Brad’s looking at his debt and wondering where to start:

My wife and I are trying to decide what to do with our “extra” income each month: pay down our home equity ($18K at 9.13%), pay down our other debt (student loans of $6K at 7.14% and $13K at 3.75%; car loan of $8K at 4.2%); or put the money into our savings account (at 5.05%).

First of all, let’s ask ourselves about tax deductibility. The only loans here likely to be tax deductible are the student loans (I’m assuming the home equity loan is a HELOC, not just a funny term for a mortgage). Also, you’ll have to pay taxes on the savings account. So, let’s figure you’re in the 28% tax bracket and re-figure the true percentages on each one:

$18K home equity loan – 9.13%
$6K student loan – 5.14% (after the tax benefit)
$8K car loan – 4.2%
savings account – 3.94% (after taxes)
$13K student loan – 2.7% (after the tax benefit)

Assuming that you are actually going to make strong contributions to your savings account, you should pay down the debts that are of a percentage higher than the savings account first. In this case, that means starting with the home equity loan, then following with the small student loan, then the car loan. At that point, you’re better off stocking up in the savings account – but the key is that you’re actually stocking up here and judging by the debt, it’s likely that you will find other uses for the money.

In that case, I recommend largely subscribing to Dave Ramsey’s “debt snowball” philosophy, except that instead of ranking the debts by the amount owed, you rank them by interest rate. That means you should do the following:

The Debt Repayment Strategy

Get $1,000 in the savings account as an emergency fund. If you have children, you may want more than that, but have at least $1,000 in there for a car emergency, etc. This way, a bad situation won’t build additional debt.

Pay off the $18K home equity loan at 9.13%. That’s an imposing debt and you need to pay that one off as soon as possible. As long as you have $1,000 in the emergency fund, focus on paying this debt until it’s gone; if you have to tap the emergency fund, focus on replenishing that back to $1,000 before paying down this debt.

Pay off the $6K student loan at an adjusted 5.14%. This is the next debt to go. Again, if your emergency fund goes below $1,000, slow down the overpayments here and build that fund back up. Now that the home equity loan is gone, you should be able to make very big payments here and knock this debt off quickly.

Pay off the $8K car loan at 4.2%. Keep rolling the debt payments forward – you should pay this one off next, paying as much as you possibly can on the principal. Again, remember the emergency fund and replenish it if you use it.

Pay off the $13K student loan at 2.7%. Even though this is a very low interest loan, I’d still recommend paying it off before building more savings. This is mostly due to it being a debt, and any debt is simply a bet that your future self can take care of it. That’s not a bet that I like. There is an argument about not paying this one off immediately, but I would get myself debt free ASAP.

Then, build a 3-6 month emergency fund in that savings account. Shoot for building up six months’ worth of living expenses in that account so that, in the event of a major crisis or a job loss, you’re fine.

When you’re there, suddenly life becomes a lot less stressful.

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  1. NCReader says:

    I thought interest from a home equity line of credit was tax deductible if the total of your mortgage plus the home equity line of credit amount did not exceed the fair market value of your home. In that case, doesn’t the IRS treat interest on debt secured by your home as “mortgage” interest even if it’s in the form of a HELOC?

  2. Kevin says:

    Generally isn’t the interest on most HELOC’s tax deductable?

  3. Toby says:

    The HELOC interest is almost certainly tax-deductible.
    I believe the limit is interest on the first 100k of a HEL OR HELOC is deductible, unless you’ve left out some detail about Brad’s finances that would make that interest ineligible for a deduction.

  4. MikeVx says:

    Er…Trent, you are not recommending the debt snowball, you are recommending the opposite. Ranking by interest rate is the mathematically best option, but that fails for so many people because of how long it takes to perceive making a dent in the highest-interest debt, which is often the highest-balance. The whole point of the debt snowball is to trade the money in extra interest for the psychological boost you get from collapsing the debts more frequently by picking off the small debts first.

    The emergency fund is a good idea regardless of the payoff tactics used.

  5. Ha'apai says:

    Ouch! The impulse to calculate effective interest rates is commendible but the application has been remarkably sloppy.

    I’m a huge fan of 1-mtr. It’s simple and it cuts through an amazing amount of deduction-worship. Unfortunately, you have to understand a thing or two about the tax code in order to use it. The HELOC is probably deductible. The 28% bracket and student loan interest combo is impossible. You start losing the student loan interest deduction long before you reach that bracket. There are also state and local taxes to consider with the student loan interest deduction and the return from a savings account.

    Bad day, eh? We all have those.

  6. Mike says:

    Also, since you described this as “Dave Ramsey’s” debt snowball, I’d point out that Dave would put the home equity loan last in the snowball, regardless of the interest rate or deductibility. He recommends ordering the debts from smallest to largest, and the home equity loan is the largest.

    His rationale isn’t based on the mathematics–it’s based on what happens to people emotionally. As you pay off debts, you get to scratch off the small ones more quickly, and start seeing debt balances go down by larger amounts sooner. These faster “attaboy”‘s are encouraging and helps you see the progress you’re making, and raises your chances of becoming debt free.

    Contrast that with paying off the largest, highest interest rate debt first–you see it go down but it seems S-L-O-W. Since you’re still making minimum payments on all the debts, your extra payment on the larger one is smaller than if you knocked them out smallest to largerst. The higher interest rate makes it seem like you’re gaining very little ground as you try to chip away at it–you take some away, and the interest puts some back, and again it’s the largest debt so it seems like you’re losing the most ground.

    This makes the “finish line” seem very far away, and makes the pile of debt seem much larger. It’s much easier in that scenario to get discouraged and give up, even if mathematically you’re making better progress by paying off a higher interest rate debt.

  7. Trent Hamm Trent says:

    I did not make the assumption that the HELOC was tax-deductible for a number of reasons, the biggest one being that it makes no difference whether it’s deductible or not, it’s still the highest-interest loan (even after figuring in deduction). He gave no information about his actual mortgage.

  8. Trent Hamm Trent says:

    Mike: this is a true worst-case scenario for Dave’s psychology-based snowball because the largest loan is also the highest-interest loan. You would be throwing a lot of money away doing it that way.

  9. Trent Hamm Trent says:

    Ha’apai: I used a hypothetical interest rate so the effect would be clear. I don’t know what his interest rate is and what’s deductible for him – I just wanted to show how to do the calculation and why it’s important.

  10. Ha'apai says:

    I agree, showing folks how to get effective rates of interest out of stated rates is extremely valuable.

    Please continue showing folks how to translate stated rates of interest into effective rates. We all should have been taught how to do this in high school — first in Algebra 1 and a second time in the first year of calculus, preferrably just after that horrible proof (theta and the word “marginal” come to mind but the rest is a blur) almost soured us on math forever. 1-mtr has the capacity to cut through an enormous amount of confusion and salesmanship. The world would definitely be a better place if more of us reflexively applied the formula to any tax-favored idea dangled in front of us.

    And please be careful. 1-mtr is a beautiful thing and you have stumbled over the most basic steps and sullied her. Her really devious tricks come into play when tax brackets are straddled, phase-outs apply, or when there are limits on the amount that can be deducted or the size of credits, none of which appear to apply here. You should not be stumbling over such elementary things as the deductibility of second mortgages and HELOCs and the income-sensitive nature of the student loan interest deduction.

    We’ve come to expect better.

  11. I think that ranking them by interest rate is a much better option as even a lower debt with a higher interest rate can cost more.

  12. Troy says:

    Tough crowd.

    I would disregard both calculating MTR and considering MTR in debt repayment.

    Too many assumptions about tax brackets, itemization, etc.

    Keep things simple. DR snowball method works best. Lowest balance to highest balance. Keeps the incentive to pay it all off the fastest.

    The faster you pay off the debt (which is controlled by emotion) the less the interest rates on that debt matter.

    Dave knows

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