The 10th Man

Which Debt Do You Pay off First?

January 17, 2019

Let’s say you are trying to get out of debt. What debt should you pay off first?

A university professor like myself might succinctly say: “You pay off the debt with the highest interest rate.”

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But there are other concerns—it’s not precisely an equation that you can solve for x.

Let’s talk about some of those concerns.

Secured vs. Unsecured

Secured debt is debt that is secured by real property. The most common example is a residential mortgage. The next most common is a car loan.

If you don’t pay the mortgage, the bank will kick you out of the house. If you don’t pay the car loan, the repo man will come with a tow truck and drag it out of your driveway while you’re eating dinner. Both are bad scenarios.

In some countries (like Canada), not paying your mortgage is the end of the world, because mortgages are recourse. Like the US, the bank kicks you out of the house and sells it. But if the proceeds don’t cover the mortgage, you are on the hook for the rest. We don’t have that here—we have “jingle mail.” It is the bank’s problem.

The most common form of unsecured debt is revolving debt, or credit cards. If you don’t pay your credit card bill, eventually the account will go into collection and you’re going to get a lot of phone calls. You’ll have a few new best buddies. A friend of a friend was once a debt collector. She actually enjoyed her job, in a sadistic way. Perfect for someone who lacks empathy.

Anyway, you can try to consolidate it, but it’s hard to make defaulted credit card debt go away. You may reach some sort of a settlement, but you will eventually have to pay it, unless you declare bankruptcy.

So which do you pay first, secured or unsecured?

Well, it’s going to be harder to pay down debt if you don’t have a place to live, and it’s going to be harder to pay down debt if you don’t have a car you drive to work.

So even though secured debt carries a lower interest rate, you should probably prioritize that first.

But, for example, if you don’t need a car to get to work, and your car only gets used on the weekends, you should probably pay unsecured debt ahead of that.

I said this was complicated.

     
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Paying the Highest Rate

Once you’re on top of the priority secured debt, you should then pay the loan with the highest interest rate (with one exception, which we will get to in a bit).

There are some personal finance gurus out there who will tell you to pay down the smallest balance first. The idea is that you can completely wipe it out and put a W on the board. It feels good, psychologically speaking, to do this.

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But it doesn’t make any logical sense.

Hypothetical scenario: you are paying down a balance that carries a 6% interest rate, but you have another balance that has a 17% interest rate. While you are busy paying down the smaller balance, you are getting whacked for more interest on the other account. You are literally losing money on a daily basis.

So if you have a big balance with a high interest rate, you should get in there and start hacking at it. Take a big chunk out of that thing every time you get paid.

I had this conversation with a family member recently, who told me he had mid-five figures in credit card debt. I was like, dude, you’re paying $7,000 in interest a year. I gave him my usual spiel, about how interest is unproductive and how he’s just contributing to bank profits.

Look, I get it. Buying things is fun. You get jewelry, watches, cars. Investing is fun. You get to buy stocks and watch them go up.

Paying down debt is no fun. You just watch the number in the account get smaller. I may be the only person in the world who finds that incredibly satisfying. I like making debt disappear, but for most people, it is like picking out socks.

Anyway, when it comes to unsecured debt, pay down the highest interest rate first—but I said there was an exception.

Student Loans

Pay down student loans first (after secured debt).

Student loans are the deadliest kind of debt. Why? Because you cannot discharge them in bankruptcy.

Meaning: they will follow you forever if you don’t do something about it.

I have a friend who worked with homeless people in New York. One of his clients got cleaned up and off the street after being homeless for over a decade. He got a job at a fast food restaurant, and five days later a couple of guys showed up looking for money for student loans, after his Social Security Number showed up back on the grid. That is just nasty.

I know some folks who make the minimum payments on their student loans, never paying down the principal, because they think that they will someday be forgiven. That is a terrible strategy.

Again, get in there and start hacking. It is not rewarding, but you have to do it. Chop and chop and chop until those things are finally gone. It might take a decade or more. It must be done.

So the answer to the question, “which debt do I pay down first?” is not simple. Which is one of the reasons I like personal finance, because there really are no simple answers. Everything is complicated. It is a massive unconstrained linear optimization problem. Stocks and bonds are easy compared to this stuff.

This is the best advice I have to offer. This is my best thinking on the subject. I hope you find it helpful.

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Jared Dillian
Jared Dillian

 

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Comments

j_berkley@me.com

Jan. 21, 7:53 p.m.

Appreciate this article Mr Dillian.

As I recall you have asked for input on other personal finance topics to cover and this article triggered a thought.  I recently have reduced my contributions to pretax retirement accounts in order to take more taxable income.  I think it makes sense.

For my income level, marginal tax is 25% up to 315K taxable income.  Prior to the new tax law it was 32%.  That’s a 7% change (or a 22% reduction in total tax)

At this point in my life I am overweight tax deferred assets and need to knock down the mortgage getting ready for retirement.  My employer does not match any contributions, so money I contribute pre tax is nothing more than tax sheltered.  I would not be surprised if a lot of people have the majority of their net worth in pretax vehicles.  Perhaps it makes sense to break out of that mold.

You might want to explore the idea that taxes are historically low for upper middle class taxpayers and now is a good time to just take income and pay your taxes on it.  There’s nothing like the flexibility of after tax cash.

Michael Berger

Jan. 17, 3:37 p.m.

As an attorney who performed real estate closings for 30+ years in three states surrounding SC, every closing of a mortgage also included a promissory note making the borrowers personally liable for an deficiency if their home were to be foreclosed.  Thus, recourse against the borrowers was always available.  It is true that the bank/lender might not pursue a deficiency judgment, but that would be their choice and in the 2008 real estate debacle, many lenders did not bother.  However, most did place it on the borrower’s credit report where it remained for seven years.

Also, have you had Dave Ramsey ghost writing your column lately?  Your articles seem geared to the financially unsophisticated, not the normal Mauldin Economics reader.

Rod Spade

Jan. 17, 2:52 p.m.

A potential reason to quickly pay off the smallest loan is that it frees up the cash flow that had been dedicated to the monthly payment.

Frederick Shanbour II

Jan. 17, 1:06 p.m.

As a finance guy, I appreciate your opinion that, in general, paying off the highest interest rate makes the most sense.  I agree that financially and mathematically, that is the best course of action.  But people who get into excessive debt don’t think financially nor mathematically.  They tend to like the “high” (emotional or physical) of buying things now whether they have the money to pay for it or not.

I was a Dave Ramsey Financial Peace University coordinator for 11 years.  I do not like Dave’s investment advice - after delivering that part of the teaching, I showed the groups multiple disastrous examples of buying 12% return growth stocks 10 years later using that buy and close your eyes approach.  However, the psychological reasons for paying off the lowest balance first are irrefutable for those that do not have a financial/mathematical mindset.  After they start seeing results, they begin to understand the financial benefits of not having debt.  If they pay off the highest interest rate loans first, they get discouraged before too long and go back to their borrowing ways to staunch the pain.  People who understand the financial suicide of excessive debt don’t have any in the first place.

Love to read your 10th man as well as ETF 20/20 and Street Freak.  Thanks!

p.eisenkramer@gmail.com

Jan. 17, 11:05 a.m.

Real estate loans are recourse or non-recourse by state