High interest debt is bad for your financial health. It continually pulls you down and makes it harder for you to move forward. Yet many people still don’t do everything they can to get rid of this sort of debt as quickly as possible.
Basically, when saving money, you can and should be using your money to make more money via investments or high interest savings accounts. However, if you have high interest debt, any investment strategy you follow will typically not yield a return higher than what the debt is costing you via interest.
Let’s take credit cards for example – some people will save money on the side in a high interest savings account and continue to only make the minimum payments on their credit cards. If your credit card interest rate is 15% p.a., by paying it off as soon as possible you are essentially outperforming any consistent investment or high interest account you could usually find.
That’s why, before you even look at investing or saving, you need to pay off your high interest debt.
Many people like the psychological boost that having savings gives them, however that’s all it is – psychological. Be smart and pay off your debt as soon as you can.
How to pay it off
There are two good strategies you can use to pay off debt if you have more than one loan (for example, a credit card and a car loan):
- Start paying off the debt with the highest interest rate first. Once that debt is paid off, then move onto paying off the loan with the next highest interest rate and so forth. This strategy makes most financial sense, and will result in the minimum in interest payments possible.
- Start paying off debt in order of the total balance, starting off with the smallest loan. One the smallest loan is paid off, move on to the next smallest, eventually reaching your largest debt. By this stage, you will only have one debt left and you can focus on paying it off. This strategy has benefits because it can really give you a motivational boost, which is often what you need when trying to get your finances in order.
What strategy is best? Financially, paying off the debt with the highest interest rate first is better. However, the psychological side of things is very important, and completely eliminating smaller debts first might be what you need to keep motivated. The main thing is to start paying off your debt as soon as you can, and keep paying it off until it is all gone!
What about low interest loans?
It depends. Once you have paid off all of your high interest debt, you might consider not making additional payments on lower interest debts such as home loans.
The theory is that if you can invest your money and get a return on investment greater than that of the debt, then it’s the optimal financial decision. For example, if your mortgage interest rate is 5% p.a., and you know you can return 8% p.a. investing in the stock market, then your overall financial return will be better by investing in the stock market. The big problem with this is that no one ‘knows’ what they can return for some of the higher-return investments such as shares. No one can guarantee any particular return in the stock market, however if you pay off your home loan you can guarantee that you will be reducing debt at a given rate.
There are lots of different strategies that will suit different people – you need to take into account your personal circumstances and seek financial advice to make the best decision for you. That being said, one thing we would all agree on is to pay off your high interest debts as soon as possible!