Interest Rates Fall Again, So Pay Down Debt

Shockingly, interest rates continue to defy the experts who predicted that either inflation or the end of QE II would push rates sharply higher.

Instead of trying to figure out where interest rates are going, or shopping for a CD that pays you 0.1% more than the one that pays you 0.2%, a better use of your money may be to pay down debt.

When you pay down debt, you basically get a return equal to whatever your interest rate is on the debt. If you're like most people, you probably carry several different types of debt, like credit cards, student loans, lines of credit and mortgages. These loans generally carry interest rates between 5% for mortgages and up to 15% or more for credit cards.

So start paying them down and get a good return on your money.

The rule of thumb is to pay down the highest interest rate debt first because that gives you the biggest return. If you have a credit card at 15%, and pay off $1,000 of the balance, you save yourself $150 of interest next year, which is like getting a $150 return on the $1,000. And by the way, it saves you $150 for every year that you would have had that balance sitting on your card. Since many people carry balances, you're likely to avoid years of additional interest by working down the debt.

The same is true of mortgages or home equity lines. While the rates are lower, and you generally do get a deduction for the interest, if you have a 5% mortgage, are in the 25% income tax bracket, you're probably still "earning" yourself 3.75% or more with that money by paying down the debt. It's tough to find a safe, fixed income investment that pays you 3.75% today.

• By the way, don't overestimate the value of the tax deduction. It reduces the cost of the debt by whatever your tax rate is. So if you're in the 25% bracket, then the deduction takes a 5% interest payment and basically reduces the cost to 3.75% after you factor in the deduction. But many people don't get to fully deduct interest payments because of various cut backs on itemized deductions, especially if you're in the higher income tax brackets. You'll have to run the numbers against your own tax situation.
• Most loans allow you to prepay principal without any penalty. But you'll want to check on that before making additional principal payments.

And even if you found a safe fixed income holding that paid 3.75%, you still have to pay income tax on that money. And if you're in the 25% bracket, it reduces your actual return to about 2.8%, so in these markets you're still likely better off paying down the debt.

Now, it's possible that if you pay down debt and then interest rates rise sharply, you may have done better by not paying it down. For instance, if rates rose to 7%, you might be better investing at 7% instead of paying off a mortgage at 5%. But you don't know whether that will happen, and you may well end up losing on this bet if rates stay lower than the interest on your debt. Certainly with credit cards there really isn't any question that paying them off first is a better use of your money. And in the end, you have to get the debt paid off anyway if you want to position yourself for a more secure retirement. So taking the return from the debt repayment now is a pretty good risk management decision.

Plus, it feels great to pay down debt and get out from underneath those lenders.

Bottom line. Low interest rates make a compelling case for continuing to pay down debt.

Above material does not serve as investment or tax advice. Individual circumstances will vary and consult your individual advisor prior to making any financial decisions. Past performance is no guarantee of future returns.
Learn More: Want to learn about a simple way to manage your personal finances and prepare for retirement, investigate my new book Your Money Ratios: 8 Simple Tools For Financial Security, available in bookstores and at amazon.com The Wall Street Journal called the book "one of the best finance books to cross our desks this year." WSJ 12/19/09.

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