3 Essential Steps in Planning a Debt-Reduction Strategy
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Don’t be too quick to pay off your debt. As strange as that sounds, debt is a powerful financial tool. When used intentionally, and in the right balance with your income and assets, debt can be a key ingredient in a healthy, growing financial portfolio.
Before you start paying down your debt more aggressively, here are 3 essential steps to help you consider all the options and create a comprehensive debt-reduction plan.
1. Determine your debt-to-income ratio
The first step in creating any debt-reduction plan is to determine your debt-to-income ratio: the amount you’re spending in loan payments every month, divided by your income.
Start by adding up all your monthly payments toward every kind of loan you’re carrying. That includes credit cards, student loans, car loans, your mortgage, any personal loans, and any other kind of debt in your portfolio.
Divide that number by your gross monthly income—not what you actually take home every month, but what you make before taxes, retirement contributions, or other paycheck deductions.
Why should you use gross monthly income instead of net? Because that’s the number potential creditors use when considering you for a new loan.
The higher your debt-to-income ratio is, the harder it is to get favorable terms when you’re applying for new credit. That limits your options in using debt as a financial tool.
If you have a high debt-to-income ratio, approaching 43% (or more), you’ll want to pay down some of your debt before you consider borrowing any more. If your ratio is under 10%, you’re in a much better position to use loans to your advantage.
How Quicken makes it easy to determine your debt-to-income ratio:
In Quicken, you’ll find your credit cards in your account bar under the Banking section. Other debts—car loans, student loans, mortgages, and more — are listed under Property & Debt.
Be sure to connect all your loans and credit cards in Quicken to see them all in one place — including personal loans and store cards like Amazon or The Home Depot.
Simply click down the list to see your monthly payment on each one. You can even categorize or tag all your debt payments together to see the total at a glance in your Quicken reports.
Once you have your monthly total, divide that number by your gross monthly income to see your debt-to-income ratio.
Remember, your calculator will show you that ratio as a decimal. Multiply it by 100 to get your ratio as a percentage. For example: debt payments of $1,000 divided by gross income of $4,000 equals 0.25. Multiplied by 100, that’s 25%.
2. Weigh your options: debt reduction, investment, and cash
Even if you have a low debt-to-income ratio, it’s still a good idea to pay down short-term, high-interest loans quickly. If you’ve taken advantage of any low-interest offers, be sure to pay those off before the expiration date.
For example, a store might offer 0% financing if you pay in full within 6 months. Make sure your monthly payments are large enough to pay the full purchase price within that 6-month window.
Once you have your short-term loans under control, it’s time to weigh your options when it comes to any remaining cash each month. Should you use it to pay down your long-term, low-interest loans more aggressively? Or should you use that money for something else?
Do you need that cash to protect your investments?
Does your home need a new roof, fresh paint, new siding, or any other significant repairs? What about any investment property you own?
Before you use excess cash to pay down a long-term, low-interest loan, run through a list of your tangible investments and make sure you have enough set aside to protect them and preserve their value.
That includes insurance, especially when it comes to uninsured real estate.
Considering the potential cost of storm damage, not to mention the consequences of not having liability insurance when you need it, an insurance policy is often a better use of cash than paying down debt more aggressively.
Do you need to replace any assets that have associated loans?
Is your car starting to have trouble even though you still owe a significant amount on the underlying loan? What about any recreational vehicles, like your boat? Or business assets, such as machinery or technical equipment?
If there’s something you’re going to need or want to replace soon that still has a loan attached to it, that’s a good argument for paying that debt down more aggressively.
Once high-value items are no longer under warranty, repairs become expensive, and replacing those items usually requires a new loan. Be sure to pay down the current loan before you’ll need a new one, and don’t get caught owing more money on an asset than that asset is worth.
Do you need to build (or rebuild) your emergency fund?
Life can be unpredictable, to say the least. Experts recommend trying to keep enough cash in easily accessible savings to cover 3–6 months of expenses just in case.
If you don’t yet have an emergency fund, or if you’ve dipped into that fund to pay for necessities, consider using any excess monthly cash to build up your savings before you pay down any long-term, low-interest loans.
Think of it this way: if something were to happen and you needed that extra cash, taking out a personal loan often comes with a high interest rate, and dipping into your retirement early triggers heavy penalties. If you have enough cash to cover the ups and downs of life, you don’t have to worry about either one.
What are your alternative investment opportunities?
Using cash to invest in a new opportunity rather than paying down debt requires a careful, and highly personal, valuation of the potential risks and rewards.
For example, let’s say you’re carrying a $200,000 mortgage at 4.5% interest. Paying an extra $500 on that mortgage each month could save you thousands of dollars over the remaining years of that mortgage.
On the other hand, that same $500 paid every month on a new investment property might earn even more in rental income and accumulated equity. Or investing that $500 per month in advertising for your small business might bring in significantly more revenue.
Before you use any extra monthly cash to pay down your long-term, low-interest debt, ask yourself what money-making opportunities you might be giving up by doing that.
That said, every investment is a risk. That’s why considering your options is such a personal choice. It’s not a matter of which one is definitively better. It’s a matter of making sure you’ve considered all your options before making a final decision.
Should you refinance before making aggressive loan payments?
When interest rates are low, like they are right now, refinancing a mortgage, car loan, or other long-term debt can yield significant savings. Before you start paying down any long-term debt more aggressively, consider refinancing options, especially if you’re likely to qualify for the best available interest rates.
The better your credit score, the lower your debt-to-income ratio, and the less you owe compared to the value of the asset (like a car or home loan), the better your options are for refinancing.
On the other hand, if you took the loan out recently, or if you’re getting close to paying it off, or if current interest rates aren’t very different than the rate you already have, then refinancing the loan probably isn’t worth it.
For help making that decision when it comes to your mortgage, read Should You Refinance Your Mortgage? 6 Questions to Ask First.
How much can you save if you make that extra payment?
Finally, if you’re considering using some extra cash to pay down a long-term loan, it’s worth finding out how much that extra payment (or payments) could save you — and over what period of time.
You’ll also want to balance those savings against your other options for that cash.
For example, if you have a 15-year mortgage at 2.75% interest, paying an extra $1,000 up front will only save you about $508 in interest over the next 15 years. On the other hand, that same $1,000 would save you $3,424 over the course of a 30-year mortgage at 5% interest.
Now consider investing that money in your retirement instead. If you invest $1,000 today at an average annual return of 6.5%, your $1,000 would grow into $2,572 after 15 years. In 30 years, it would grow into $6,614.
These kinds of calculations can get complicated, and you might want to consult a financial advisor before making any final decisions. But playing with a debt calculator can help you develop a better understanding of your options as you consider, or discuss, your choices.
How Quicken makes it easy to weigh your debt-reduction options:
Whenever you add a loan to Quicken, be sure to include the loan terms so you can make the most of Quicken’s debt planning tools.
For example, the What-If tool lets you run various loan scenarios, such as making an extra lump-sum payment or paying an extra amount every month.
Just enter the payment option you want to explore. Quicken will show you how the extra payment or payments will change your financial situation, including how much interest you’ll save over the term of the loan and how much sooner you’ll pay off the debt.
3. Track your net worth
No matter what you decide to do with your extra cash — save it, invest it, or pay down your debt — the important thing is to keep track of how your financial situation is changing over time.
Are your savings and investments growing? Is your debt shrinking? More importantly, how are they changing in relation to each other?
That last question points to one of the key performance indicators you should be tracking when it comes to your financial position: your net worth.
Net worth is a measure of how your assets and debts are changing when compared to each other. You calculate it by adding up the value of all your assets (from the cash in your bank account to the value of your home) and subtracting the total value of all your debts.
When you track your net worth over time, you’ll get a clear sense of how your financial situation is developing. If your net worth is dropping, that means your debts are growing faster than your assets. If your net worth is growing, then your assets are growing faster than your debts.
How Quicken makes it easy to track your net worth:
In Quicken, your net worth is displayed at the bottom of your account bar. That shows you the total value of your assets minus your debts today.
To see your net worth over time, visit the Reports tab. The net worth reports are built in. Explore the reports to see your net worth as a table of numbers or displayed as a line graph over any period of time you choose.
If your net worth is negative, that’s not necessarily a bad thing. A negative net worth usually means you’re either just getting started or you’ve recently taken on a new loan for an asset that hasn’t yet appreciated (like a student loan or a home loan).
It could also mean that you added a loan to Quicken without adding the underlying asset associated with that loan. For example, when you add a mortgage, be sure to add the mortgaged property as an asset account and record its current fair market value.
Remember, taking on debt can be a smart financial choice. After all, “It takes money to make money.” When you take on a new loan to buy a home, start a business, or purchase an investment property, you expect that new investment to pay off over time.
As long as the total value of your assets — including your new home, business, or other new investment — keeps growing relative to your total debts, you’re headed in the right direction.