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Paying off debt wisely
Paying Off Debt Wisely

When you're paying off debt, should you also be putting money into savings accounts or investments or should you wait until you are debt free?  This is an age-old question with one of those annoying answers: It depends. Let's take a closer look at getting out of debt!

You've probably heard that simplistic solution: Always invest if you can earn a higher interest rate from your investment than you are paying on your loans.

Is this true? It's not necessarily that simple when you are getting out of debt! In fact, this can be dangerous. Remember the stock market frenzy? Unfortunately, a lot of homeowners added to their debts by using refinancing or home equity loans. When the bear market hit, the reason that this solution is not so simple after all became far too clear. Far from being debt free or paying off debt, many people simply increased their debts.

Evaluating your debt

So, how do you decide how to most effectively use the money you earn when you are getting out of debt? The best answer lies in separating good debt from bad debt. It's almost always a good idea to get rid of credit card borrowings and other high-interest loans before you start saving cash. However, you probably don't want to accelerate loans such as mortgages at the expense of saving for your retirement.

Feeling overwhelmed? Here are some steps you might consider following when paying off debt to become debt free:

  • Make a list:  List all of your debts and the interest rates you are paying on each of them. This will help you prioritise which ones you should pay first. Don't skip this step and just assume that you automatically know where your highest rates are—you might be surprised! Then look at your alternatives for saving and investing, and if necessary, reset your paying off debt priorities.

  • Pay off the high-interest debt:  Firstly, sort out paying off debt on high-interest credit cards. Based on the interest rates of most credit cards, you'd have to make a whopping 20% after-tax return on investment products to make them a better investment than getting out of debt with a credit card with an interest rate above 15%, so you're definitely smarter paying off the cards until you are debt free instead of investing.

    Exception: If your employer offers a pension plan and will match your contributions up to a certain level, fund it up to that level—even if you have credit card debts—because you'll get a 100% return on your investment.  Drowning in debt? Consider liquidating assets such as shares and use your savings for paying off debt.

  • Know which debt is good debt:  Unless you have piles of extra cash sitting around, it's usually not worthwhile to pay off your mortgage until you are generally debt free. This is because interest rates on mortgages tend to be low and the chances are that your mortgage has the lowest interest rate of any of your other debts.

    Exception: Close to retirement? Getting out of debt should be a priority! Try to pay off your mortgage and any other debts before you retire so that you can get by on less money. Or, if you have student loans, there's not necessarily a big rush here either as the interest rates you will be charged will generally be low in industry terms.

  • Save and invest:  Finally eliminated your high-interest debts? Now that you're debt free and don't have to worry about paying off debt or getting out of debt, it's time to start saving as much as you can. The best place to begin is a company pension scheme if you have one. Alternatively, look for tax free investments such as ISAs. Aside from a pension, you'll also need a contingency fund. This is cash that is readily available in an emergency, so that you don't have to rely on credit cards or other loans products. A good rule of thumb is to have three months' living expenses set aside (or six months if you have a variable income or a job that has exposure to economic fluctuations). Keep putting spare cash in a high interest account each month until you reach your target amount.

When figuring out how to become debt free, keep these “getting out of debt” and “paying off debt” tips in mind!

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