When people first become acutely aware of their personal finances, they’re usually hit with a cavalcade of seemingly incompatible goals. They usually have a number of debts that they’re facing covering a variety of different interest rates. At the same time, there’s usually a strong demand to start saving for retirement or saving for a child’s college education or saving for a down payment. There may also be other goals on the horizon, like a career switch or a return to school.
How does a person even decide how to juggle those priorities?
Most financial gurus agree on one thing: High-interest debt is horrible and should be eliminated first. If you have debts with interest rates above 20%, you’re going to want to get rid of those as fast as possible. Simply sitting on a $1,000 debt with a 30% interest rate means that $300 of your money each year is evaporating into smoke without even touching the balance of that debt. There’s no question about it – that’s a financial disaster and you have to deal with that as soon as you can.
On the flip side of the coin are zero-interest loans. You borrow $1,000 from someone and they charge you no interest on that loan. They only require that you pay it back at a regularly scheduled rate. With that extreme, there’s no real incentive to pay back that loan with any speed at all. You’re better off just sticking the money in a bank account and paying it off as slow as possible and just collecting the bank interest for yourself! It makes virtually no sense to prioritize paying off this debt early when you have any other savings goals at all.
Those scenarios represent two extremes. Most people have debts that are somewhere in the middle of that. They have a credit card at 12%, a student loan at 6%, a car loan at 3%. How do they figure out which debts should be addressed as a top priority and which ones should lag in line behind other financial goals?
In other words, what is that “magic” interest rate above which you should prioritize paying off that debt and below which you should prioritize other savings goals beyond a simple emergency fund?
The difficulty with this question is that you’re going to get very different answers from different financial writers. Some are going to strongly prioritize debt elimination and will suggest a very low “magic” interest rate, prioritizing rapid pay down of even fairly low single-digit interest loans like car loans. Others will prioritize aggressive investing and will basically tell you to not bother rapidly paying of anything in the single digits or low teens.
They’re both right. They’re both wrong, too.
A person’s “magic” interest rate isn’t based on something set in stone. Instead, it’s one of those things that puts the “personal” in personal finance. There are a ton of factors that play into which debts you should prioritize before a strong focus on saving for the future and which debts you should wait on. (In fact, there’s a good argument that you should prioritize some savings in different ways, but we’ll not worry about that here.)
Here are five factors that make up a key part of this number.
Factor #1: Cash Flow / Overall Debt Load
If you’re struggling to come up with enough cash at the end of the month to even cover your bills, you need to be focusing on debt repayment rather than saving for goals. When you’re in a situation where you’re walking a tightrope each and every month, your mission should be to maximize the gap between your income and your expenditures as quickly as possible. You have to prioritize debt repayment.
If you’re not struggling to come up with enough cash each month to pay the bills and you can actually handle some career and life setbacks without financial armageddon, then you don’t have to put as much emphasis on debt repayment.
Most Americans are in the first category; remember, 76% of Americans live paycheck to paycheck. In my experience, most financial writing tends to target people in the second category, and thus they tend to focus more on savings than on debt as compared to the average American’s needs.
In summary, if you’re struggling to keep the bills paid, your “magic” interest rate should be lower, not higher.
Factor #2: Risk Tolerance
Once you’ve really committed to spending less than you earn, the choice to repay debt is a lot like investing in something with a guaranteed tax-free return. For example, if you’re paying down a 15% debt, that’s a guaranteed 15% return on your money after taxes. That’s a better return than stocks or real estate can provide in most years.
This is really the big argument for paying off debts until one starts to approach the long-term average annual returns of stocks or real estate, somewhere around 7% or 8%. Above that, it’s pretty hard to argue that investing is going to improve your finances as quickly as eliminating debt.
The issue starts to get trickier in that 7% to 8% range. Some people simply do not have the stomach for the volatility of many investments. Watching their retirement savings drop by 20% or 30% in value over the course of a year can cause them to make panicked moves out of stocks, which only guarantees their losses. They’re not tolerant of the risk.
Ask yourself honestly what you will do the next time the stock market lurches and you have a healthy amount in stocks within your retirement plan. Are you going to stay put as you watch the value of your retirement drop by 3% per month for several months, or are you going to get nervous and bail? If you’ll truly stay put, your risk tolerance is high and thus your magic interest rate should be 1% or 2% higher than average. If you’ll bail (and many people will), then your magic interest rate should be 1% or 2% lower than average.
Factor #3: Short-Term (1- to 5-Year) Plans
If you’re planning on making a major career switch or other major life change that will either drop your income level or put your income at risk, then cash flow becomes paramount. And when cash flow is paramount, the most important things for you to do are to eliminate debts and have cash in hand (from savings in a savings account).
In other words, your risk tolerance becomes very low because you can’t afford to lose much money in the coming years, thus you definitely lean toward paying down debt and your “magic” interest rate drops through the floor, down to as low as 2% or 3%.
If you’re hoping to keep things on track and are aiming to progress in your current career and perhaps build income, then preparing for the long term is what matters most and you can actually bolster your “magic” interest rate a little bit because of the long term power of compound interest in your retirement plan and other long-term tools. After all, you’re moving in a direction where you won’t need to tap it for a very long time.
- Related: The Freedom to Quit Your Job
Factor #4: Interest Rates Going Forward
If you have variable-interest loans, such as an adjustable-rate mortgage, a student loan with variable interest, or a credit card that can adjust the rate, projections of future interest rate hikes from the Federal Reserve should definitely impact your “magic” rate. If the Federal Reserve is expected to raise rates in the coming year, your “magic” interest rate should go up by that same amount when evaluating variable interest loans.
This has no impact on fixed-rate loans. Most mortgages and car loans and many student loans fall into this category. Thus, if that makes up the bulk of your debt, you really don’t need to worry much about this factor at all.
Factor #5: Proximity to Retirement
This is another “cash flow” issue. If you’re close to retirement, the most important thing in the final few years as you coast into retirement is to ensure that you have your bills as low as possible so you can make ends meet on your already existing retirement savings. That’s because, with such a short time frame, most retirement investments are very volatile and may not retain value for you.
Never dump cash into the stock market or real estate if you’re going to need it in the next few years. So, in this situation, your “magic” interest rate should be really low.
On the other hand, if you’re far from retirement, anything you save for retirement has a ton of time for the power of compounding to work in your benefit, so you should actually raise your “magic” interest rate a bit in this case.
What’s Truly Important?
For most people, these factors are going to be pointing in a bunch of different directions at once. If that describes your situation, then I’d keep my “magic” interest rate somewhere close to the long-term expected return of the stock market – around 7%. If your debts have a higher interest rate than that, focus primarily on paying those debts off. If your remaining debts have an interest rate below that, then focus on your savings goals and use any extra to keep making progress on your debts.
If most of the factors point toward a higher “magic” interest rate for you, bump it up by a few percentage points and switch over to saving once you’ve eliminated all debts above 9% or 10%. On the other hand, if most factors point toward a lower “magic” interest rate, focus on paying off all of your debts that don’t have a zero interest rate.
The key thing to remember is that this isn’t an exact science. You’re simply trying to make the best moves for you, and these are factors that can push you one way or another. It’s also important to remember that simply spending less than you earn and doing something productive with the remnants is the only truly important thing here. It doesn’t matter too much what you decide to do regarding a 7% interest rate debt because paying off that debt early and putting money away for retirement are both good moves, and you’re not really going wrong either way. This just gives you some guidelines when you’re trying to decide which one to choose.
Good luck!
Related Articles:
- In What Order Should I Pay Off My Debts?
- Should New College Grads Pay Down Student Loans or Start Investing?
- Two-Sided Coin: Is Debt the Devil?
The post Your ‘Magic’ Interest Rate: Figuring Out Debt vs. Savings appeared first on The Simple Dollar.
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