A little bit of debt can be a good thing. If you approach borrowing strategically, you can eliminate higher-interest debt that may be weighing you down, lock in low-interest loans and use the extra cash to boost your investments for retirement or contribute to an emergency fund.
Now is a particularly good time to scrutinize the debt side of your ledger. Interest rates on most kinds of loans should remain low even as the Federal Reserve continues to target higher short-term rates, which would increase payments on many variable-rate debts—notably, most credit cards and home-equity lines of credit, as well as some private student loans. Below, we’ve arranged the most common types of debt roughly in the order of payoff priority. Generally, if you have a FICO credit score of about 740 or 750 or higher, you’ll qualify for the best rates on any type of loan. But some lenders will offer low rates to borrowers with scores closer to 700.
Credit cards. Unless you’re milking a 0%-introductory-rate offer, there’s a good chance that any credit card debt you are carrying is costing you a bundle, making it a prime candidate for accelerated payments. Interest payments don’t qualify for a tax deduction (except for those on expenses related to a business), and the average rate on cards that charge interest is 13.9 percent, according to the Federal Reserve.
Explore ways to trim the rate, such as transferring the balance to a home-equity loan or line of credit, personal loan, or a new credit card. Several credit cards charge no interest for the first 15 months and levies no balance-transfer fee as long as you move the money within 60 days of opening the account. Whatever card you’re considering, account for the annual fee and any balance-transfer fee (typically about 3 percent of the balance) before you decide whether the move will be worthwhile. If you have a limited-time low-rate offer, make a plan to pay off as much of the debt as possible before the deal expires.
Another option: Ask your issuer to lower the rate on your current card. About two-thirds of customers who did so were successful, according to a recent CreditCards.com survey.
Auto loans. The average rate on a four- or five-year bank loan for a new car was recently about 4 percent, according to the Fed. But in 2015 through November, nearly 10 percent of dealer-financed car loans had 0 percent interest rates, reports Edmunds.com, and Edmunds expects such offers to continue for “qualified” borrowers (often those with a credit score of about 700 or higher). If you nab a great deal on a car loan, making minimum payments could be a smart move. You can use the cash you would have spent up front on the car for savings or investments.
But the collateral (your vehicle) is a depreciating asset, so you could end up “underwater”—owing more on the loan than the car is worth. Avoid loans that stretch the repayment term beyond five years. If you are already committed to a longer-term car loan, try to increase the monthly payment beyond the minimum to build equity more quickly. And if you’re not paying a rock-bottom rate, look into ways to refinance. You may be able to get a better deal by moving the debt to a home-equity loan or line of credit or by refinancing with a new lender. Check out the rates Mutual of Omaha Bank has on loans and credit lines.
Student loans. The interest you pay on student debt and your options for repayment depend on whether the loans are federal or private and the type of loan you have within each category. Direct subsidized and unsubsidized federal loans for undergraduates granted from July 1, 2015, to June 30, 2016, carry a fixed rate of 4.3 percent; your rate may be lower or higher if you took out the loan at another time. Private student loans come with a fixed or variable rate.
Whether you have federal or private loans, don’t miss out on the tax break: You can deduct up to $2,500 a year in interest payments if your modified adjusted gross income is up to $65,000 for a single person or $130,000 if you’re married filing jointly. The deduction phases out eventually, disappearing if your income is $80,000 or more on a single return or $160,000 or more on a joint return. Check whether you can get a discount (often a 0.25-percentage-point reduction on interest) for having payments automatically withdrawn from your bank account.
Generally, federal student loans provide more avenues for flexible repayment, says Mark Kantrowitz, publisher and vice president of strategy for college information site Cappex.com. Plans for overburdened borrowers with federal loans include income-driven repayment (which caps your payment at 10 to 20 percent of your income), extended repayment, and deferment or forbearance (which allow you to delay or reduce payments).
If you have a private loan and are having trouble keeping up with payments, talk to your lender. Relief programs can save you from default in a pinch, but putting as much as you can afford toward student debt is optimal if you’re on solid financial ground. You may save money by consolidating or refinancing your loans, but consider whether you can save just as much by paying off your current loans more quickly.
As a parent, you may be helping your kids by taking on debt yourself, such as a federal PLUS loan or private loan, or paying off your student’s loan with a home-equity line of credit (HELOC). Parent PLUS loans come with fewer options for repayment than federal loans that your student takes on, but they are eligible for extended repayment, deferment and forbearance. A parent PLUS loan is also eligible for income-contingent repayment (payments are usually capped at 20 percent of your discretionary income) if the loan entered repayment on or after July 1, 2006, and if it’s part of a Federal Direct Consolidation Loan. Or having your child make payments to you to help cover your debt (at a lower rate than the student would pay otherwise) may be a win-win.
By Lisa Gerstner, Copyright March 2016, From Kiplinger’s Washington Editors