We all know that interest rates have leapt up quickly in the past 18 months. Whilst many people have been protected thus far by fixed rate mortgages, as these roll off, more and more of us are starting to feel the pain. That being the case, paying off debt has bubbled to the top of the priority list for many. This week I wanted to explore some of the ways that you might be able to accelerate paying down your debt.
Debt Snowball vs Debt Avalanche
Debt Snowball and Debt Avalanche are two popular strategies for paying down debt. The difference between the two lies in the order in which you tackle your debts. They are therefore only applicable for those with multiple types of debts. So for instance a mortgage, some credit card debt, and perhaps a car loan.
With the Debt Snowball approach, you make a list of all your debts and then order them from the smallest balance to the largest balance.
You make the minimum repayments on all these debts, and then focus all of your surplus into paying off the smallest of the debts, so the one that’s at the top of your list.
Once this first small debt is paid off completely, you’ve now freed up the minimum repayments that were going to that debt and you can direct this money, plus your surplus into the second debt, accelerating its repayment. This process is repeated so that after a period of time you end up with just the largest debt, likely the mortgage on your home, and then all the money that was getting wasted paying off credit cards and the like can now be directed at this loan.
This approach has two attractions. For one, psychologically it’s great to be able to see debts cleared and know that they are behind you. With this approach you can often get some quick wins. The smallest of your loans might be able to be cleared in the space of a few months, which can be great positive reinforcement and really help you continue to make progress.
With the Debt Avalanche approach you again make a list of all your debts, however here you order them based on highest interest rate to lowest interest rate. Note that to do this accurately you should adjust the interest cost of any loans that are tax deductible to reflect the after-tax cost.
The repayment approach is the same as with the Snowball method. Focus all your energy in paying off the first loan on your list, and then once that’s gone put everything towards the next debt.
The Debt Avalanche approach is mathematically superior to the Snowball method, however many people find more success with the Debt Snowball approach due to the psychological benefits of achieving some early wins.
Principal and Interest vs Interest Only
Most loans are principal and interest in their structure. This means that with every repayment you cover the interest expense whilst also paying something off the principal debt, so that the value of the loan reduces over time. Sometimes though loans are interest only. Most commonly this relates to investment property loans, though if you only pay the minimum on your credit card this is close to interest only as well.
Check your loans and if you have some that are interest only, find out from the bank what the repayments would become if you moved them to principal and interest. The interest rate will almost certainly be lower for a principal and interest loan, and so you might find that the monthly or fortnightly repayments aren’t greatly different if the loan was rejigged as principal and interest. In the long term such a change would save you considerable interest costs, helping you build wealth and financial security.
Debt consolidation
If you find yourself with multiple debts, debt consolidation can be away to get on top of things. This would be applicable for someone where they’ve perhaps got a personal loan for some furniture, a car loan, and maybe a mortgage. In this circumstance you could reduce the total cost of your debt by refinancing all the loans into a single mortgage. Being secured against your home, the interest rate on this new loan would be considerably less than the interest on unsecured debt.
The thing to watch with this is that you continue to pay off the personal loan over the same period of time. If you had a loan for some furniture that you bought at Harvey Norman with $2,000 payable over two years at a 15% interest rate, it would seem a no-brainer to refinance this onto your mortgage at 5.5%. But this can be misleading.
If it takes you 30 years to pay that amount off on your mortgage, you will end up paying an amazing $5,688 in interest! Whereas had you stuck with the original two-year loan, even though the interest rate was almost triple the cost. The interest you would have paid is a 10th of that, $567.
So the key with making debt consolidation work is maintaining your current level of repayments if you possibly can.
Refinancing
Mortgage brokers have been kept busy this past year refinancing fixed rate loans that have expired. Competition amongst the lenders has been fierce though I understand it’s eased off a little recently. Nonetheless it’s worth exploring whether there’s an opportunity to refinance your loan and get yourself a better deal. Speak to a broker or just do some internet research yourself, then talk to your bank and see if they will at least match the best you can find elsewhere. If they can’t, it might be time to make a switch. Just be sure to have clarity on all the costs associated with the change.
Offset accounts
Offset accounts are magnificent. The effective rate of return is whatever the interest rate is on your loan, but there is no tax applicable. For someone with a mortgage, it’s very likely that your offset account offers the greatest return available for your cash savings.
Consider whether you could use an offset account. Could your emergency fund be an offset account? How about your bills account? Got another account where you save for holidays, perhaps that could become an offset account. All of these will reduce the interest expense on your loan, and mean that every repayment you make is knocking down that principle a little bit more.
Motivation
Accumulating debt is usually much more fun than paying it off. And unfortunately, much like a big night out, the duration of the hangover far exceeds the time it took to do the damage.
Remaining motivated and sticking to your debt reduction plan can be challenging. Recognise this from the outset and set yourself some goals. Perhaps it’s getting your total debts down to a certain level, or if you’re using something like the Debt Snowball approach, perhaps it’s getting rid of a particular debt that’s been hanging around your neck for years. When you reach these milestones celebrate. Ideally not in a way that racks up more debt, but I’m sure you can find inexpensive ways to pat yourself on the back.
Another way to address the motivation challenge would be to keep some sort of tally on the fridge or the wardrobe door and cross the numbers off as the debt goes down. There’s always something pleasurable in physically crossing something out and knowing it’s behind you.
Time to downsize?
This idea is a little more extreme, but if you’re really struggling under the weight of debt, perhaps it’s time to consider whether your current arrangements are sustainable. Feeling like you’re struggling to keep your head above water is hugely stressful both on you as an individual, and if you have a partner, on your relationship. Financial stress is one of the key reasons given for divorce.
If debt is weighing you down, consider whether it’s time to bite the bullet and accept that you just can’t afford to continue living where you are. Not easy I know, but potentially it’s something that you look back on a few years down the road and question why you hadn’t made the change earlier.
Tax deductible debt and wealth creation
Not all debt is equal. Debt used to purchase assets that generate taxable income is tax deductible. When working out your debt reduction plan, you need to make an allowance for this. Determine your marginal tax rate, and adjust down the interest cost to reflect the effective cost to you. It’s quite likely that an investment loan with a headline interest rate half a percent more than the loan on your home, is actually cheaper once you factor in the tax deductibility of that debt.
I ran some numbers for a client recently who had an investment loan of 7.75%. We found that after tax and allowing for the dividend income from the investments, we only needed to achieve growth of a little less than 1% per year for the whole strategy to remain viable. Tax deductible debts can be more affordable than they look.
Well I hope that gives you a few things to consider. Debt is essential for building wealth. It’s almost impossible to buy a home in Australia without taking on debt, and most wealth creation strategies require leverage to accelerate the outcome. Interest rates have risen sharply but by historical standards they’re not especially high. We’ve just got a painful adjustment that we’ve got to work through. So if debt is causing you stress, take action and put yourself in a sustainable long-term position.
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