Randomly picking which debt to pay off first is not the ideal strategy—especially considering the magnitude of the average American’s debt, as well as rising interest rates.
In 2017, the average American household had more than $130,000 of debt, made up of home mortgages, credit card debt, student loans, and auto loans. It’s no wonder individuals have a hard time prioritizing their payments. Choosing the right approach to pay off debt is not a simple task, and there is a lot to consider before making a decision.
Tax Law Changes Interest Deductibility
The recent passage of the Tax Cuts and Jobs Act changes the availability of interest deductions for payments on certain types of debt.
In the past, the interest paid on up to $1 million of debt for a qualifying home mortgage was deductible. For houses bought after December 15, 2017, this number decreases to $750,000 (until 2026, when it reverts to the $1 million cap). Furthermore, the interest paid on many home equity lines of credit (HELOCs) may no longer be deductible, even for HELOCs opened before the passage of this act. (In 2026, the rules revert, and interest on up to $100,000 of home equity debt is deductible again.) Fortunately, student loan interest payments will continue to be deductible under the new tax plan, with up to $2,500 deductible for both single and married filers. This deduction phases out as a taxpayer’s adjusted gross income increases.
Rising Interest Rates Impact Mortgages
The Federal Reserve is expected to raise interest rates steadily over the next three years, targeting a short-term Federal funds rate of 3% in 2020. This rising interest rate will strongly impact the housing market; a higher rate will limit the number of buyers who qualify for a mortgage, and it will increase the monthly payment for those who qualify. These effects may mean that some taxpayers will be paying more interest.
Arriving At the Best Strategy
Assuming equal interest rates, taxpayers should focus on paying off their nondeductible debts first. Quickly eliminating debt that has no tax benefit is a smart choice.
If interest rates differ, then the prevailing rule is to pay off debts with the highest interest rates first. However, this answer may change if a portion of the interest payment is deductible.
Taxpayers must also consider opportunity costs. Paying off nondeductible debts and eliminating high-interest debts may seem like great choices. For some taxpayers, though, the opportunity costs of not using that money elsewhere may outweigh the benefits of paying off those debts early.
Don’t Leave It to Chance!
We all know that randomly choosing which debt to eliminate is not ideal; there is so much more to consider. Your CRI professional can help evaluate your payoff strategy and guide you toward the best choice.