A new client recently arrived in certified financial planner Stephanie Genkin’s office with a troubling debt situation: $250,000 owed on student loans and $25,000 in credit card debt.
The client “was focused on trying to pay down the student loan, but I saw the danger more in the credit card debt for a couple of reasons,” said Genkin, founder of My Financial Planner. “It showed she couldn’t afford her lifestyle when she rang up that debt, and the interest rate on it was about four times higher than her student loan debt.”
It’s a scenario encountered all too often by Genkin and other financial advisors: People saddled with different types of debt but struggling to pare it down in the most strategic way.
“Often, clients will look at the total owed and focus only on that instead of looking at interest rates on the different debts and seeing how fast it’s going to grow if you don’t get ahead of it,” Genkin said.
“It should always be the No. 1 goal to tackle,” said Matthew Crisafulli, a CFP and financial advisor with ACap Asset Management. “The interest compounds in the wrong direction … and it gets out of hand quickly.”
According to Bankrate.com, the average interest rate on credit card balances is about 16 percent. And with total U.S. credit card debt creeping north of $750 billion, it’s no wonder financial advisors recommend focusing on that debt, even though the balances of other debt — student loans, mortgages, car loans — often seem more intimidating.
The point is that a higher interest rate ends up costing you more. So if you have the choice of throwing extra cash at a high-balance, low-interest-rate loan or at lower-balance, high-interest-rate debt, you spend less in the long run if you focus on the latter.
If you face several credit cards with different interest rates, advisors say it’s financially wisest to follow the same prioritization of paying off the balances with the highest rates first. But, they acknowledge, sometimes paying off the smallest balance first can help people remain committed to their goal.
“If I run the numbers and it’s a difference of, say, $250 after several years, then I’ll recommend paying off the lowest balance first,” Crisafulli said. “That can make them feel empowered by paying it off. That’s a balance between what’s financially practical and what’s emotionally realistic.”
Sometimes, depending on the level of credit card debt, advisors recommend reducing that debt even before saving for retirement.
“Typically, if the credit card debt is more than $10,000, we want that paid off before saving for retirement or a [house] down payment,” Crisafulli said.
This debt — a whopping $1.3 trillion of it — is the trickiest to tackle, financial advisors say.
Federal student loans typically have interest rates in the 4 percent to 6 percent range, depending on the exact type of loan. Private student loans, on the other hand, can come with rates in the double digits.
Genkin of My Financial Planner said that many people with lower-interest loans should avoid throwing extra money at student debt at the expense of saving for retirement.
“Some people say they’ll pay off the student loan first and then start making retirement contributions,” Genkin said. “That’s absolutely wrong.
“When you go through your credit card bills and see what you spend the money on, it can be eye-opening. Denial is over at that point.”
“You want to get the tax break [for retirement contributions] and the company match [on 401(k) plan contributions],” she added. “It’s better to have that money invested 30 to 40 years.”
If it’s possible to consolidate or refinance your student loan debt, it’s a move that can lower the interest rate you’re paying. Additionally, repayment options for federal loans are intended to make the debt more manageable.
But CFP Alex Koury cautions that sometimes a repayment plan that’s intended to be affordable can result in the minimum payment not covering the interest.
“Then you’re only paying interest, and any shortfall is tacked on the back end of the loan,” said Koury, vice president of investment planning for Householder Group Estate and Retirement Specialists.
Financial advisors say that despite what many people think, the goal shouldn’t necessarily be to pay off your mortgage as soon as possible.
If you’re paying under 4 percent on your home loan, any extra cash you have should go toward retirement (assuming you don’t face high-interest credit-card debt).
“If you have that much extra money, put it in your retirement account,” My Financial Planner’s Genkin said. “The truth is that you can be making more money by investing that money for the long-term than by putting it toward prepaying your mortgage.
“Most people have under-saved for retirement and that’s what they should be focusing on,” she added.