If there is one personal finance principle that you can agree on almost everywhere, the first thing to do is to pay off your high-yield debt, and then keep paying it off. The accumulation of high interest debt is up devastating to your finances because of the sheer amount of money that drains from your checking account Nothing in return.
What About Low Interest Debt? What if you have a 3% or 4% debt tied up? Does this debt also have to be repaid? Where exactly is that line between high and low interest debt?
Before we get into that, we should be clear about the benefits of making additional payments on a debt. When you receive an invoice for a debt in the mail, look at two key numbers. The first is the principal, or balance, which is how much you currently owe. The second is interest. That is how much extra you owe that has been built up since your last payment. It is based on multiplying your principal by the interest rate.
For example, if you owe $ 1,000 at 12% annual interest and make payments once a month, your interest on your next payment will be $ 1,000 times 0.12 (that’s 12%) divided by 12 (since it’s one month ) of the 12 months of the year), which means you owe $ 10 in interest.
This is important because The amount of interest you owe each month goes down as you pay off the principal. If you reduce this principal to $ 500, you owe only $ 5 in interest that month. Additional debt payments will go completely to the headmaster, which makes it so much smaller. So when you make an additional debt settlement, you’re lowering the amount of interest you’ll pay each month from now on (assuming you don’t add more to that debt). That’s why it’s so powerful!
What is a “low interest debt”?
A low-interest debt is any debt with a lower interest rate than what you could easily get on an investment. Depending on your investment perspective, this number is between 7% and 12%. Warren Buffett believes future investment returns should be around 7% per year, making 7% a pretty safe line between low- and high-yield debt.
You should pay off high-yield debt as soon as possible because there is essentially nothing better you can do by investing with no significant luck. It’s a pretty good guaranteed return on your money (assuming you’re no longer accumulating high-yield debt).
It gets a bit more difficult with low-interest debt, as repaying low-interest debt early has both advantages and disadvantages. Some people even consider low-interest debt to be “good debt” because of some drawbacks.
Advantages of early repayment of a low-interest loan
The benefits of paying early on a low-interest debt include:
- Less monthly billswhich means that you will not have any more financial stress in any way. It always helps to have less money on bills every month.
- Improved cash flowwhat happens by shrinking or eliminating bills. Paying off debt means paying off a smaller batch of bills each month, which means you can survive and live on a lower income or have more cash to save for long-term goals.
- Financial progress also happens when you pay off a low-interest debt. This is money that doesn’t go away in the form of interest.
Disadvantages of early repayment of a soft loan
The disadvantages of paying off a low-interest debt early include:
- Locked up moneybecause money that might be readily available in a savings account is now “tied up” in your loan. For example, you could have $ 5,000 in debt and $ 1,000 in savings, or $ 4,000 in debt and $ 0 in savings. While it’s nicer to have less debt, it also means you don’t have $ 1,000 easily accessible in an emergency, and that can quickly lead to credit card debt in an emergency.
- Opportunity costsThis is an extension of the “money imprisoned” problem. When you pay off a debt, it means you don’t have the cash to take advantage of an opportunity. When you put that $ 1,000 into a loan, you may not have the $ 1,000 to get great benefit from replacing your refrigerator that is nearing the end of its life.
Don’t pay off a low-interest loan early
Unless you have other financial plans, your best strategy is to pay back high-yield loans first, then make minimum payments on soft-interest loans, and do other things with an additional payment, like building an emergency fund or kicking off pension contributions.
An emergency fund is useful because it acts as a buffer to keep you from borrowing high-yield credit card debt in an emergency. For example, if your car breaks down and needs to go to the store, you can just tap on an emergency cash fund instead of putting a balance on a credit card. This should be your top priority once you are in control of your high yield debt.
If you have an emergency fund, make sure your retirement savings are well looked after. Increase the contributions to your company pension scheme. If they offer the appropriate funding, you are contributing enough to get every penny of it.
Except in these situations
Are there times when you should consider paying back a low interest loan quickly? The only time you should consider taking such a step is when you already have an emergency fund and you know your monthly income is about to go down.
For example, if you’ve saved a few months in the cost of living and are considering a career or job change, with lower monthly bills it will be much easier to move into a period when less income may be being collected. Another example is when you retire on a fixed income like a pension when you know your monthly income is lower and surviving month to month is much easier when you have fewer bills.
In these situations, however You should prioritize a healthy emergency fund on the repayment of low-interest debts. Only pay off the debt after you have a few months of living expenses in case things go bad.
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