You are Superman, and debt is your Kryptonite. If you're already Financially Competent(or think you are) you can probably come up with a dozen situations where debt is actually a good idea. In some of them, you'd actually be right. But if you're Financially Competent enough to use debt correctly, you're not in the target audience for these Financial Competence articles. If you're still striving for Financial Competence, as I am, your primary goal should be to eliminate all debt. Your recipe is simple:
- Save as much as possible
- Pay the minimum on each debt, except the one with the highest interest rate
- Pay off the debt with the highest interest rate with every cent you can squeeze out of your budget. Debt is an emergency.
- Once you have that debt paid off, move on to the one with the next highest interest rate and repeat until you are debt free.
Paying off debt takes precedence over investment. It takes precedence over everything except the Emergency Fund and other Essential Responsibilities.
What's our situation? Through the tiny amount of Financial Competence my wife and I had before we got married, neither of us has any credit-card debt. My wife has a student loan currently charging 5.12%, and I owe back taxes to the IRS that are currently accumulating interest and penalties at 3.25%. We're paying the minimum on my IRS debt, and putting every penny we can save into paying off my wife's student loan. If we're reasonably diligent, we can pay off the student loan in two years. If we can manage to save more than 30% of our gross income, we can do it in one year. And it may be another year after that before my IRS debt is paid off. That's three years to be debt free, and three years before we can start accumulating assets and investing them. But every dollar we put towards the student debt earns us a 5.12% return. While we might be able to get higher returns by investing, we also might get lower returns. The return on paying off the debt is guaranteed. Every $1,000 we put towards the student loan earns us $51.20.