Generally the best returns are to pay off all non-deductible debt. First, credit cards, second, personal loans and third, home mortgage.
Better still, avoid credit card debt like the plague!!
Also, always save a hefty deposit on anything you might otherwise finance on a personal loan and buy what you need, not what you might like to have - saving $5000 before buying and buying a $5,000 cheaper car so you borrow $10,000 less can give you a substantial interest saving, particularly if you borrow over a shorter period (making higher repayments) as well.
Assume you have a debt of $1000.
To pay $200 of 20% non-deductible interest on a credit card debt of $1000 out of after tax earnings if you are on a 40% marginal tax rate you have to earn 333.33 (Amount to be paid divided by (100 – marginal tax rate) multiplied by 100: 200/(100-40)*100 = 333.33
To pay $150 of 15% non-deductible interest on a personal loan of $1000 (eg for a car) out of after tax earnings if you are on a 40% marginal tax rate you have to earn 250.00 (Amount to be paid divided by (100 – marginal tax rate) multiplied by 100: 150/(100-40)*100 = 250.00
To pay $100 of 10% non-deductible interest on a mortgage debt of $1000 out of after tax earnings if you are on a 40% marginal tax rate you have to earn 166.67 (Amount to be paid divided by (100 – marginal tax rate) multiplied by 100: 100/(100-40)*100 = 166.67
To pay $100 of 10% tax deductible interest on a mortgage debt of $1000 out of after tax earnings if you are on a 40% marginal tax rate you only have to earn $100.00 because you get a tax deduction and so don’t have to earn extra to pay the tax on the extra earnings.
In summary, the amount you have to earn to pay one year's interest on a $1,000 loan using the examples above is :
1. Credit card 20%: 333
2. Personal loan 15%: 250
3 Home loan 10%: 167
4. Investment loan 10%: 100
Another way of looking at this is to gross up the interest rate to a pre-tax rate:
1. credit card rate is 33.3%
2. personal loan rate is 25%
3. home loan rate is 16.7%
4. investment loan rate is 10%
So generally the greatest after tax return comes from paying off non-deductible debt, and it is worth ensuring that you have sufficient spare cash, even in very low interest paying accounts, that you never have to pay interest on your credit card.
This analysis can be complicated by taking capital gains into account on investments and depending on anticipated capital gain it might be worth using your surplus to invest in stocks rather than pay off your non-deductible home loan if the market has just fallen 50% and it has turned up and just broken through the 100 day SMA.
It may even be worth borrowing more against any “surplus” equity you have in your home to make such an investment, even though you are not paying down non-deductible debt as fast as you could.
But to keep it simple for now, first pay off all non-deductible debt, starting with your credit card, then personal loans, then home loans, and when you only have your home loan left, use an offset account so your savings are all offsetting your home loan until you need them to pay bills.
If you need to borrow using a personal loan eg for a car, make sure that your lender will allow you to pay it off faster without any additional costs. This may mean that you need to ensure that the loan is a floating rate loan. This way you can take a longer loan period to give yourself a margin of safety, but pay it off fast.
The golden rules are:
No credit card debt
a) never spend on a credit card anything you can't pay off in the interest free period
b) never take a cash advance from a credit card,
c) in fact run your with a small credit balance
Debt and Investing
Pay off all non-deductible debt first