Credit cards, car loans, mortgage, home equity lines of credit, student loans… Does the mountain of debt ever get any smaller? There are many different types of debt out there and knowing which debts you should you pay off first and which ones offer tax incentives can be an important concept to understand.
Tax Deductible Debt
For many tax payers, the interest on mortgages and home equity lines of credit are tax deductible for both personal residences as well as rental property. Student loan interest is also tax deductible for many tax payers. For this reason, these types of debt are often referred to as “Good Debt” because of the tax savings they offer at year end.
Unfortunately, there seems to be many more forms of debt that most likely will not offer tax incentives at year end, such as credit card debt and car loans. This does not mean these forms of debt are completely unwanted, or necessarily worse than Tax Deductible Debt, but it is important to know the differences. For example, a car loan with a Annual Percentage Rate of 1% is by far less costly than a student loan with an APR of 6%, even factoring in possible tax savings.
So what debts should I pay off first?
Generally speaking, debt with the highest effective interest rate should be paid off first. For nondeductible loans, this is the interest rate. For tax deductible loans it is usually the interest rate times 1 minus the tax rate. Due to individual circumstances such as your income level, tax bracket, and the interest rate associated with all of your debt, it is nearly impossible to know what debts you should pay off first without knowing more information and speaking to a qualified Accountant or Professional. At Glen Barger & Sons Accounting Services, we can work with you directly to understand your unique situation to get you to where you want to be, which is financial freedom! Call or email us today to schedule your appointment for your 2010 Income Tax Preparation. During your appointment we can speak about your financial situation, including what debts you should pay off first!