Past financial mistakes and missed opportunities aren’t the only kind of financial baggage I’ve sorted through. I include debt as a form of financial baggage because it’s something that you’ll have hanging over your head until you pay it off. But it’s more concrete since there are numbers (and bill collectors!) attached. The good news is that this actually makes debt a much more straightforward form of baggage to deal with. In my case, a little research helped me quickly decide which loans to target for rapid repayment and which to keep in favor of directing free cash flow elsewhere.
In that research, I found a couple of good resources that I’ve shared on the Resources page. I’ve always known better than to carry a balance on my credit cards because of their ridiculously high APRs and I’ve appreciated the value of a mortgage’s tax and investment benefits. But I wanted a little guidance on where to draw the line on other forms of debt like student loans.
The rule of thumb I used to make the call was to compare my after-tax cost of borrowing to my after-tax return on investing. It’s important to consider the after-tax cost of borrowing because that lowers the true cost of debt for things like mortgages since you can deduct them from your federal taxes. It also means that you should consider the tax advantages of investing in a 401K plan, especially if there’s an employer match. Other things to consider are liquidity and risk tolerance. Most financial planning sites I’ve seen point out the importance of setting aside 3-6 months of liquid assets for emergencies before you do anything else.
Here’s a quick order of priority list from Bogleheads. Obviously this will depend on your personal situation and rates at any given time. For someone like me, though, who often falls into the trap of not making a decision because I’m too caught up in all the details, a rough guide like this was helpful (and sufficient!)
- Invest in 401(k) to get maximum employer match
- Pay down credit cards (rate 10-30+%)
- Pay down non-deductible auto/student loans/other medium-rate loans (rate 5-8%)
- Invest in Roth IRA, deductible IRA or decent 401(k) (rate 5% on Treasury bonds)
- Pay down deductible mortgage or student loans (rate 4% after tax)
- Invest in taxable account (rate 4% on municipal bonds)
- Do not pay down subsidized loans as long as subsidy lasts (rate 0-3%)
All the sources I used to research this topic are on the 'Resources' tab.