If you're like many people, you're carrying a debt load that you'd rather not have, and you'd also like to be accumulating funds for retirement. When a few extra dollars come your way, it can sometimes be hard to decide what to do with them. For example, you might spend them, pay off debt, or invest them.
The stock market can be particularly tempting, as stocks can increase in value by double digits sometimes. It's not easy to focus on how to pay off debt when you're looking at a biotech company that might double next year. Things are not quite what they seem, though. It becomes a simpler matter when you understand this: Paying off loans can actually deliver the biggest bang for your bucks.
Consider these typical interest rates that many of us face on our debts:
- Car loan: 3% or more
- Mortgage: 4% or more
- Home equity loans: 5% or more
- Student loans: 7% or more
- Credit card balances: 16% to 20% or more
Now consider that the average annual return of the overall stock market, historically, is about 10%, and that it's often less than that. Sure, in 2009 the S&P 500 soared about 26%, and in 2012 it gained 16%. But in 2005 it added less than 5%, and in 2007 not much more than 5%. In 2011 it gained only about 2%, and in 2008... well, it plunged nearly 37%.
Bigger -- and guaranteed
Put all of this information together, and what to do becomes clear. By paying off any part of a debt with a 5% interest rate, you essentially earn a guaranteed 5% return on it! If you're saddled with a lot of high-interest rate credit card debt, well, that's indeed rough. But the silver lining is that you can earn big double-digit returns when you pay off that debt. If you pay $1,000 toward a loan charging you 20%, you're saving yourself from having to fork over some $200 annually on that debt. In fact, if you left that $1,000 principal in place, you'd be paying a lot of interest on it year after year -- so by paying off that debt you can save a lot of money!
How to pay off debt
Actually paying off debt can be easier said than done, though. Still it's not impossible, even with huge sums. Here are a few suggestions for how to pay off debt:
- Tackle your highest-interest rate debt first, as it will save you the most money over the long run. Then move on to lower-rate debt. Ignore minimum payment amounts and make maximum ones, paying down as much as you can.
- Rein in as much of your discretionary spending as possible. There are powerful sums to be saved simply by cutting out a few luxuries such as a daily Frappuccino or a service you rarely use. Review your regular expenses, too -- you may no longer need collision coverage on your car insurance, for example, if the car is very old.
- If having a credit card in your pocket makes it too tempting to charge items you don't absolutely need and may not be able to pay for right away, consider making your purchases only with cash or checks.
- You might rearrange your debt by paying off higher-interest-rate credit card debt with a lower-interest home equity loan or by moving your balance to a lower-rate card.
- You might even consider taking on a part-time job for a while, to generate extra income. That probably doesn't sound like an appealing option, but if you add 10 hours per week at $15 per hour for just one year, that's $7,800, pre-tax.
- Don't let yourself be discouraged now or later. Get inspiration from folks who have paid off many tens of thousands of dollars in debt. You can learn a lot about how to pay off debt from them.
How to pay off debt becomes a simpler matter once you see how powerful an investment in your future it really is, and once you create a plan for actually doing it.
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