Pay off Debt Wisely using New Wealth

It may not seem exciting, but using newly acquired wealth to pay off debt is almost always the best course of action. If you have existing debt, especially high interest-rate debt, use your newly acquired capital to eliminate it. You'll increase your cash flow by reducing monthly payments, save the money you're paying in interest, and improve your credit rating.

Each situation, however, is different and there is no one size fits all answer. Let's look at a couple of examples: one with a clear-cut decision, while the other is a more complicated.

Say you have a $3,000 balance on your credit card. (The average Australian carries a balance of nearly $3,200.(Reserve Bank of Australian Figures, August 2008)) Your interest rate is 18 per cent and you make the minimum payment of $75 per month.

If you never make another purchase using the card, and you continue making your minimum payment only, it will take 62 months to pay off the card - and you will have paid over $1,600 in interest.

Clearly paying off the card - immediately - is the best choice you can make.

Now let's look at a different example: paying off your home loan. You could choose to pay off the entire balance, or you could choose to pay extra each month to pay off the loan more quickly. Say you have a 30-year, $300,000 mortgage at 8% interest. By paying an extra $100 a month, you save nearly $89,000 in future interest and pay the loan off four and a half years early.
Sounds great, right?

Yes, but here are some potential problems. Mortgages, because they are secured by a tangible asset, tend to have low interest rates. That interest can be deductible, if borrowed for income producing purposes and reduces the amount of overall tax you pay.
Plus, much of your savings will occur in the future where inflation could erode their value. For example, $100,000 in 25 years is worth less than $48,000 in today's dollars, assuming a moderate three per cent inflation rate.

And you won't have the advantage of using someone else's money to invest, losing the power of leverage.

Or you could choose to pay off your entire mortgage? but that can create financial inflexibility. If most of your new wealth goes into paying off your mortgage, you will reduce the amount of emergency funds you have on hand. If you have liquid savings equal to three to six months of expenses, it could be the difference between surviving a rough patch and facing financial disaster.

In short, pay off debt wisely - and within the parameters of your overall financial plan.