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By Katie Pins
Living with debt can easily keep you up at night. Wouldn’t you like to pay off all of your debt while keeping up with your savings goals? I would too! However, many of us have to find a balance between paying off loans faster and ensuring we have enough savings for an emergency-- oh, and paying our monthly bills.
Almost all loans can be paid off early. You can save money by paying off the principal on your loan early because extra payments can significantly reduce the amount of interest paid over the life of your loan. Therefore, the larger the interest rate and loan, the more money you can save by paying off your debt early -- as long as there are no prepayment penalties on your loan. The important thing is to prioritize which loans to pay off early and how to make those extra payments easier.
Paying off debt early seems like it’s always the right thing to do because you will save money on interest in the long run. However, sometimes it is best to stick with making those monthly payments. You should take into account a few key things before you pay off a loan early including interest rates, prepayment penalties and your savings goals.
The interest rate on your loan is the most important thing to consider when choosing whether or not to pay off a loan early. First, look at the interest rates on all of your debts and prioritize the loans with the highest rates.
You’ll probably find that your credit cards have the highest rates. If you have more than one credit card with a revolving balance, you will want to start paying off the one with the highest first. You could also consider transferring your balance from a high-interest credit card to a low-interest card. That way, a high interest rate won’t hold you back while you work toward paying off your debt.
Loans with lower interest rates such as mortgages or car loans will not be as high of a priority. At the very least, make sure you’re paying those installments on time while you work on paying off other debt.
Another thing to consider is whether or not your loan comes with prepayment penalties. Read the fine print on your terms and conditions. A prepayment penalty is a fee you could incur if you make extra payments above your installment. A lender will have a prepayment penalty because they make money off of your interest payments. Many lenders don’t have these types of penalties, so it helps to do your homework.
Prepayment penalties can be structured in different ways. Here is an example: You have an auto loan payment of $600 a month. In order to pay off your debt faster, you pay $800 one month. If you have a prepayment penalty of 3 percent, you will have to pay an extra $24. These fees could add up, so it may be in your best interest to not make extra payments toward loans that have penalties.
If you suddenly lost your job, would you have enough in the bank to last six months? If not, then you may want to contribute to an emergency fund instead of making extra payments on your loans. Yes, you could save money in the long run by making extra payments on your loans, but those future savings cannot help you if you have a hiccup today.
Your retirement savings should also be a priority. Try to maximize your employer’s 401(k) match because, thanks to compound interest, the money you contribute today could grow significantly 20 to 30 years from now.
Credit scores have a tremendous impact on our lives. You may be surprised by how often your credit is pulled, including when you apply for an apartment rental or during employment background checks. Since a good credit score is essential, you’ll want to do anything you can to score an even higher credit score.
The type of debt you are paying off will impact your credit score differently. Reducing your debt on revolving accounts like a credit card or home equity line of credit will impact your credit score differently than installment loan accounts like a mortgage, personal loan or student loan.
Why? Your credit score is determined by a few key factors, including credit utilization, which makes up 30 percent of your score. The credit utilization score is the ratio of your total outstanding credit to your total credit limit. For example, if you have two credit cards with a total balance of $4,500 and a total credit limit of $30,000, your credit utilization percentage is about 15 percent. Any utilization score below 30 percent is good. Anything below 10 percent is even better. So, paying off your credit card debt until your utilization is below 10 percent will be really good for your overall credit score. Asking for a higher credit card limit could also help the credit utilization portion of your credit score.
Your payment history makes up 35 percent of your credit score. Both your revolving accounts and installment loans are factored into this part of your credit score. No matter how you prioritize your debt-free-plan, it’s important to make your monthly payments on time on all your loans. A common misconception is that a closed loan or credit card no longer affects your credit score. The fact is that even though those accounts are closed, the payment history on those accounts could be with you for up to seven years. A few late payments could really damage the credit you’ve built. With that in mind, you could tackle your high-interest debt first, but don’t forget any payments toward your personal loans or car loans during that process.
In general, if you are making extra payments to a loan, you want your payments to apply to your principal, not your interest. By paying to your principal, you can reduce the amount of money you pay on interest as well as reducing your loan.
This tip is an easy way to make a big difference over time, so the extra payments don’t hurt your wallet one month over the other. Round up your payment to the nearest $50 or $100 each month. For example, if your car loan is $430 a month, round up your payment to $450 a month or even $500 a month. Make these payments automatic, so you can set it and forget it. Over time, this strategy can help you make your payments, pay off the loan early, and save money on interest.
Did you get a bonus this year? How about some awesome cash back rewards on your credit card? You can make larger payments toward your debt by using this extra cash. If you think of it as bonus money, you will be even more excited about seeing it go to work for you! Reducing your debt and interest payments is a great way to utilize this hard-earned cash.
It can be incredibly hard to cut expenses, so we created a six-month plan to help you cut expenses slowly. When you cut an expense, try to make it a permanent cut. As you cut your monthly expenses, log your savings and put that total amount of cash toward your loan each month. Again, make this payment automatic at the beginning of the month, so you’re not tempted to spend this money elsewhere.
You could refinance your car loan, student loans or your mortgage, just to name a few!
This tip is best if you have high interest rates, multiple years left on your loan or if you have a better credit score than when you took out the loan. By refinancing, you could reduce your monthly payments or the term on your loan, which could save you money on interest.
Once you’re done paying off one loan, take the money you were paying on it and apply it to the next loan. Since you were already used to paying that amount, you won’t miss that money. This snowball effect can help you pay off the next loan faster and then the next one even faster.
Talk to friends and family about how they were able to pay off their loans faster. Sometimes, the best advice on how to reduce debt can come from the people who did it. Also, sharing your goals is a good way to hold yourself accountable and stick to your goals.
When you make reducing your debt a priority, you could put more money in your pocket and the benefits could help you for years. You could reduce your debt-to-income ratio, making it easier to get an important loan such as a mortgage in the future. Most importantly, when you reduce your debt, the peace of mind you receive is priceless, and you’re setting yourself up for a better future. Good luck!
Katie Pins is a marketer fascinated with finance. Whether the topic is about the psychology of money, investment strategies or simply how to spend better, Katie enjoys diving in and sharing all the details with family, friends and Money Mentor readers. Money management needs to be simplified and Katie hopes she accomplishes that for our readers. The saying goes, "Knowledge is Power", and she hopes you feel empowered after reading Money Mentor.
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