When you owe money, who do you pay off first?

Photo:  Consumers Union

Photo: Consumers Union

A few readers have asked some very good, specific debt-related questions — particularly who should be paid off first and who should be paid off last. Before we get into it, getting out of debt is an art, as compared to getting in debt being a sport. Here is my best advice for you debtors.

Regarding paying on your credit cards, always pay the minimum payment and at least an additional 10 percent. Please do not think that is impossible to do, if the minimum payment is $250, then you should send in at least $275. Concentrate your focus of payments on the card with the smallest balance (yes, you read correctly) versus the highest interest rate. Why? You will gain greater satisfaction from being at least one card free than the savings differential of paying down the card with the higher interest charge.

If you are paying off a friend or family member, make sure they always get paid on a regular basis. If they say they do not want it until you have the full balance, just know they are not telling you the truth. The truth is that they do not want to keep track of the payments. So you will send in the payment with a little note that says, “Here is another $100 on my original $1,000 loan, this now leaves a balance of $650. Thank you again for your confidence in me.” Yes, you must do this. It is a thank you note and a reminder to them you are not like the “other” family members and that you have learned something.

If you are paying on a car loan, you want to set up the payments to be automatic. A late payment will haunt you on your credit report for seven to 10 years. I have had to explain why I was late on a minivan payment in June of 1994 almost as many times as I rode in the minivan. Thankfully, it has been a while. I recommend here that you make substantial payments (double payments) if you can. This is not a great debt to have because the asset (your car) that you borrowed against is depreciating. The last thing you want to do is pay interest on an asset that is depreciating. (I like leasing better than buying as with a lease you are only paying for the use of the car.)

If you are paying off student loans, you want to be aware that student loan interest is tax-deductible. Hence if your student interest rate is as high as 8 percent, and you are in the 25 percent tax bracket, your real after tax cost of borrowing is  8 percent (100 – your tax rate = your after tax cost of funds). For example, 8 percent multiplied by 0.75 = 6 percent. Just be aware that your actual after tax cost of borrowing might be lower than you initially thought. I recommend that you first consolidate all your student loans, stretch them out as long as possible (yes, up to 30 years), and to have the smallest possible payment and give yourself the option of making larger payments. Also have payments deducted automatically from your bank account, which usually saves you as much as 0.5 percent on the loan.

Now, as you begin to enjoy your success and hard work any and all, raises and bonuses should be directed as follows: one third to your retirement account, one third to your student loan balances and the last one third to you to spend as you see fit. If you are paying on your home loan, remember as with the student loan the actual after tax is lower than the stated interest rate. This is the last loan you should make accelerated or extra payments. Why? Because the leverage “the debt” you have on your home is the primary factor in your actual rate of return from your home investment. Basically, in real estate unless you are going to live there during retirement you are just borrowing the house. The less you have invested, the better return you will enjoy when you sell.

The opinions and recommendations expressed herein are those of Mr. Garrido and do not necessarily reflect those of the firm and are subject to change without notice. This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities. The information contained herein has been derived from sources believed to be reliable but is not guaranteed as to accuracy and does not purport to be a complete analysis of the security, company or industry involved.

What do you think?