Many individuals who face whopping debts wonder what the best strategy is to pay it off.
The answer depends on multiple factors, according to Tim Steffen, director of advanced planning at Baird.
Coming up with a plan for how to handle your bills is important. Doing so will put you ahead of many Americans, more than a quarter of whom have no plans for paying off their debts, according to a recent LendingTree report.
That's an expensive misstep, considering the average credit card balance Americans are carrying has climbed to $6,375, a three percent increase from one year ago, according to Experian.
Here are four things to keep in mind when whittling down what you owe.
Look at the interest rate of the loan compared to the rate of return you could potentially earn with that cash.
"If you can earn more on that investment than you're paying on the debt, you're probably better off … keeping the debt, because you're going to earn more with that cash than you're paying," Steffen said.
List out your debts, including the balances and interest rates. (Take note if the interest is potentially tax deductible, say, for a student loan or mortgage. That will lower your borrowing costs.)
Next, prioritize the loans you pay off by interest rate, also known as the avalanche method. This strategy means that you will attack the highest cost debts first. (See infographic below.)
Another technique, the snowball method, works by paying off debts from smallest to largest. But that can be more expensive because it does not take interest into account, Steffen said.
"Some people like to focus on maybe your smallest loans and paying those off first," he said. "I tend to look at it more from what's the most expensive and let's pay those off first."
Different kinds of debt affects your life differently, positively or negatively.
Debt that helps set you up for long-term goals, like a mortgage to purchase a home or student loans to fund your education, can be considered good debt. Those loans are helping you to build an asset.
But depreciating assets that are not tax deductible, such as credit cards, are generally considered bad debt.
"Determine what's the good kind and what's the bad kind, and try to avoid the bad kind as best you can," Steffen said.
You may sleep better at night knowing that you don't have outstanding debt. In that case, it will make the most sense to pay it off.
"If it makes you feel better, if you sleep better, if you're into retirement perhaps a little better without having the debt, then by all means pay it off," Steffen said. "There's something to be said for that peace of mind."
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