All forms of debt are not equal, so it’s important to prioritize your obligations before you pay them down. It actually pays to have some forms of debt. Home mortgage interest, for example, on acquisition loans of up to $1 million are fully tax deductible. Mortgage interest on a second home can also be deducted in many cases. Meanwhile, $2500 of your student loan interest can be deducted if you’re a single taxpayer with a modified adjusted gross annual income of $50,000 or less, or a married couple filing jointly earning $100,000 or less.
In addition to serving good purposes, these loans also happen to charge relatively favorable interest rates. Anyone who purchased a new home recently or refinanced their existing mortgage is paying only around 5 or 6 percent interest. In 2003, student loans were being consolidated at 4 percent rates or lower. By comparison, the average credit card was charging nearly 15 percent, and many were charging 21 percent or more. It seems obvious, then, that you should pay off your cards first. Not only do cards charge the highest rates, the interest isn’t deductible. And by paying off your cards first, you’re also likely to improve your credit profile faster. A person’s credit score—used by lenders to set interest rates on loans—factors in that person’s mix of Debt, and unsecured revolving debt is looked upon less favorably than mortgage debt.
After you’re done paying off your cards, attack other forms of high-rate nondeductible debt, such as car loans. Then work your way down the food chain. If you have a home-equity loan outstanding, consider paying that off next. Home equity loan interest is deductible provided the loan itself does not exceed $100,000. Home-equity loan rates also tend to be relatively low. And the money can be used for any reason, such as paying off credit cards or going on vacation.
Home equity loans aren’t always desirable, however. Despite rising home values, many Americans own less of their houses today than 20 years ago. That’s largely because of the record amount of equity we pulled out of our homes through “cash-out refinancing,” where a homeowner refinances a mortgage for more than is currently owed on the property, in order to pocket the difference. To whatever extent you can restore that equity, great. Despite the attention we pay to our stock portfolios, our homes are by far our most valuable assets. Among middle- and upper-middle- class families, home values represent more than 40 percent of total wealth (versus just 17 percent for retirement accounts). It’s in our best interest, then, to own a larger percentage of this appreciating asset.
Next, pay off the student loans, particularly if they charge higher rates. Finally, that leaves you with the mortgage, which offers the most flexibility of all debt. And thanks to record–low-interest rates at the start of this decade, it’s also probably your lowest-rate loan. The amount you save each month and the amount you set aside to pay down debt ought to be based on what you make and what you need to live on. That’s a simple budgeting exercise.