What is the best way to get out of debt? While there is no magic solution to make your debt suddenly disappear, there are methods you can use to help you get out of debt as quickly as possible.
In this exclusive LoveToKnow interview, Curt Andringa, Senior Financial Manager, reveals the best way to get rid of your debt as well as methods for staying out of debt in the future.
Interview with a Financial Manager: A Plan Is the Best Way to Get Out of Debt
LoveToKnow (LTK): What is the single best method for getting out of debt?
Curt Andringa (CA): Having a plan and budget is the best way to get out of debt. There are different approaches you should take with each type of debt, including mortgages, auto loans, education loans, credit cards, and business credit.
Let's assume that you've already come to the conclusion that you need a plan to get out of debt. You need to first consider the facts at hand. How many types of debt do you have? For example, do you just have credit card debt or do you also have an auto loan? The average person carries two to four types of debt. Knowing how many types of debt you have is critical in putting a plan together because of how different each type is with respect to interest rates, tax implications, time periods, payment schedules, and security.
LTK: Is there a particular order in which consumers should pay off debt?
CA: The most common type of debt is credit card, or what I'll call consumer debt. The average person probably carries four different credit cards. If not managed appropriately, this is by far the worst type of debt to get into and almost always the first debt someone should pay off. The other types of debt generally come with their own plan to pay them off as dictated by their payment schedule.
To determine the debt payoff order you should consider the interest rate on each first, and secondly, the tax implications. Generally, an auto loan will have the highest interest rate (around nine percent), followed by your home (approximately three to seven percent), and lastly, any education loans (generally one to four percent). Like consumer debt, auto loans have no tax deductions associated with them. Home mortgage interest is tax deductible as an itemized deduction (though not all people itemize). Education interest is deductible as an adjustment to income (before tax) and is thus the most tax advantageous debts to carry.
To sum up then, since auto loans usually carry the highest rate and have no tax advantageous, after credit cards, you should pay off an auto loan first (unless you have a zero percent loan), followed by your home, and lastly your education loans. This should be the general order as part of your plan to pay off debt. This should be coupled with a personal budget to determine how much you can afford to pay in debt payments or whether you should even be in debt at all.
The High Cost of Debt
LTK: Why should people bother getting out of debt?
CA: The cost of carrying debt is high. Consider a home loan of $200k. If you carry a home loan over 30 years at the average (historical low) rate of 5 percent, you'd end up nearly paying for your house twice over that period of time. That's not to say you shouldn't have a home loan, but it just shows how much interest can play a part of one's personal budget.
LTK: Why is a budget so important when trying to get out of debt?
CA: Having a budget is at the core of good financial stewardship. Without a budget you greatly increase the chances of getting yourself into a hole that you can't get out of. Having a budget allows you to see all the ins and outs of your financial picture.
LTK: Should people empty their savings to pay off debt?
CA: As a general rule, savings should be done in combination with debt repayment. On the other hand, if you are carrying consumer credit card debt at a rate of 15 percent or more then there are very few reasons why you should be saving instead of paying off that debt. There aren't too many surefire 15 percent investment opportunities out there. Outside of credit card debt, it is generally a good plan to save in combination with a home, auto, or education loan. There are tax advantages to saving through a 401k, IRA, or pension plan through your place of employment.
LTK: Should people cash in retirement accounts or investments to pay off debt?
CA: Occasionally people get into big enough problems with debt that they consider cashing out a 401k or another retirement plan to pay off the debt. This should be done only after very careful discussions with a tax advisor, as there are stiff penalties for withdrawing money prior to a retirement date set by the plan. In general, you are better off finding another source of income to pay off the debt.
More About Curt Andringa
Curt worked for a CPA and financial advisory firm before deciding to exit the public accounting life and enter corporate finance. He now works for TD Ameritrade as a senior manger of finance for the technology division with an inactive status for his CPA certification.