Classifying your debt: The Good, the Bad and the Ugly
Back in June, I asked “what’s our next early payoff challenge“. We have credit card, auto and student loan debt, plus our mortgage (but that doesn’t count right now). I was really leaning towards paying off our credit card debt next, even though it’s at 0% interest, whereas our student loans and auto loan are at least 4.5%. Guess which debt we took on next. Yep, the credit card debt.
You may call me stupid, foolish, or dumb for not paying off our highest interest rate first, but it’s not always about money. Let’s take a closer look at our debt, and think about it in a new way:
If there’s a general consensus on a good debt, it has to be student loan debt. Personally, I think all debt hurts, but student loan debt probably garners you the most benefits of any of your debt, including a mortgage. As of writing, we have a little under $27,000 in student loan debt:
- Mike: $14,705 at 6.25%
- Stacie: $11,734 at 5.75%
We both started at about the same debt level (even though Stacie has her Masters and I’m just starting on mine), but we paid a few grand more on Stacie’s when trying to get rid of some loans when we consolidated.
I consider my “bad loan” to be my car debt. At one point, we had $53,000 in auto loans, but now we’re down to less than half that total now. Also we just sold a car this past weekend for $10,500, but we have other plans for that money.
- Mike: $22,330 at 4.50%
The only debt left has to be the ugly one: credit card debt. Why is it ugly? Because I can’t think of much that I have left to show for that debt. It’s been following me around for years (yeah, so has the student loan debt), but I’ve finally taken action against it. We’ve gone from $20,000 in credit card debt down to under $6,000 in about 17 months.
- Mike & Stacie: $5,687 at 0% (until November)
So, back to our debt payoff schedule. Why would we pay off the 0% interest debt before the student loan debt (the highest interest)? Not all debt is equal:
I mentioned in “Is the thought of debt ruling your life?” that we have plans to be debt free in order to have the freedom for one of us to stay at home with our future child, or to be able to move closer to our families. This means that we think about our debt in 2 dimensions:
- The monthly cost of our debt. That is, how much of our monthly payment goes towards interest. Ultimately, this all adds up, which is why debt is bad. You’re paying way more for your stuff than it’s worth.
- The risk of each debt.
Let’s talk about risk a bit more…
The Risk of Your Debt
What do I mean by debt risk? Think of it this way: If you had our debt load, and you fell into a financial hardship, which debt is the hardest to overcome?
- Student Loans: You are able to defer your student loans in times of financial hardship. However, if you’ve consolidated your and your wife’s loans together, you BOTH have to have problems to be able to defer. Also, the student loan companies are generally willing to renegotiate your payment plan so that you can still make your payments without stopping them.
- Auto Loans: You can always sell your vehicle. In our case, I could sell the truck and we’d be down to 1 car. Or I could downgrade to something used at half the price. In your case, you may already have a dirt-cheap car, or may owe more on the loan than the vehicle is worth, but you can still sell it and reduce your monthly obligation.
- Credit Card Debt: What can you do for your credit cards? You can purchase a protector plan (for a per $100 balance fee). For a $10,000 loan, the average cost will run you $80-150 per month. Whoah! That’s not something the credit card company tells you when they offer this plan, is it?
Credit cards are the riskiest of the three debts because you have to PAY money to insure yourself against risk, while the other two have built in escape routes. Now, I’m not advocating for all of you to go ignoring your other debts over your credit cards, because in your scenario, paying down your non-credit card debt may make more sense. In our case, we want to be in a better position to handle future problems, or to make ourselves more open to opportunities if they come by (e.g. a great job offer back in PA).
So call me silly if you will, but this is my reasoning, and I’m sticking to it.