One of the most common questions we get from clients is "How do you know when to save versus when to pay down debt?" Regardless of whether your debt is student loans, credit cards, etc, to answer this question, we first take a look at the concept of debt.
Think of debt like a bucket of water. The water represents your net worth and debt represents holes drilled into the bottom of the bucket. The higher the interest rate, the larger the hole and the more of a priority it should be because the faster you're losing water.
We break interest rates into 3 levels:
We recommend that debt with an interest rate at or above 8% should be aggressively paid off. With interest rates this high, it's very difficult to refill the bucket faster than you are losing money so it's best to stop the leak.
Debt below 5% is considered "good" debt. This means that your debt has low enough interest rates that it doesn't economically make sense to pay it off early because you can generally achieve a higher return with a sound investment strategy. We're not suggesting not paying off debt, but just simply using your money as efficiently as possible.
The debt that falls into the 5-8% level is what we call "emotional" debt. This is where your personality comes into play. If having this debt doesn't bother you then continue to pay the minimums and utilize your dollars more effectively elsewhere. On the other hand, if this debt drives you crazy and keeps you up at night, then by all means, actively pay it off. While we believe in tactical debt management, it's important to maintain your personal quality of life.
Written by Kristin R. Brandli, Financial Advisor
North Star Resource Group