A reader owes five figures in credit card debt but is about to turn a six-figure profit selling her home. Where should the extra cash go?
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Question: Once my house sells, I will have $140,000 in profit. I’m going to buy a new place for $100,000 — but I also owe $60,000 for credit cards and other debt. Should I pay cash for my next home and use what’s left over to pay off as much debt as possible? Or should I put $50,000 down and get a $50,000 mortgage so I can pay all my debt and have some leftover for emergencies? – Bonnie H.
Laura Adams, author, and host of Money Girl podcast responds…
Thanks for your question, Bonnie! I’m glad you’re focused on paying down debt because it’s a critical part of a healthy financial life. The types and total amounts of debt you can handle depend on your goals and the bigger picture of your finances. But in most cases, you should opt for paying off the credit card debt first. Here’s why….
A mortgage is considered “good debt”
In some cases, using debt is a smarter move than spending cash, especially for a home. That’s because mortgages are relatively inexpensive debt. The average 30-year fixed-rate mortgage cost about 10% in 1990, but today (2019) 4% rates are widely available. There’s also been hints that the Federal Reserve may lower rates, which could drop mortgage rates even lower.
One reason a home loan comes with a lower interest rate than other types of debt, such as credit cards or personal loans, is because it’s secured by the property you purchase. Not only can a lender foreclose or take your home back if you don’t pay a mortgage as agreed, but you also go through a strict approval process.
The tax benefits of mortgages
Another unique benefit of having a mortgage is that it can cut your taxes if you claim the mortgage interest tax deduction. A tax deduction saves money because it reduces your taxable income, which lowers the amount of income tax you have to pay.
When you borrow money to buy, build, or remodel a home, you’re allowed to deduct the mortgage interest you pay each year. Depending on how much you earn and your tax rate, claiming the deduction could reduce what you owe or increase your tax refund by thousands of dollars.
Beginning in 2018, you can deduct interest paid on your main home and a second home on mortgage balances up to $750,000 (or $375,000 if you’re married and file taxes separately). This is down from $1 million or $500,000 for loans taken out in previous years, which is still deductible.
The main requirements to claim the mortgage interest deduction are that:
- your debt is secured by the property
- you have an ownership interest in the home
- you file taxes on Form 1040 and itemize deductions on Schedule A.
Is credit card debt keeping you from success? Learn how to get your debt under control.
Another financial goal you may have missed
There is another financial goal besides paying off debt that you didn’t mention and that’s savings. If you’re not saving at least 10% to 15% of your income for retirement, then you may want to prioritize that goal instead of paying off any debt ahead of schedule.
You might also want to consider using some of the funds for emergency savings, if you don’t have an emergency fund set up. Once you send money to a lender to pay off a loan or credit card early, you can’t get it back if you fall on hard times or have unexpected expenses. A good rule of thumb is to always keep an emergency fund equal to at least three to six months’ worth of your living expenses.
Even though there are advantages to having a mortgage, you should never get one that’s more than you can afford. Make sure you can handle the monthly payment, plus property taxes, insurance, any homeowner association dues, and estimated annual home repairs.
Bonnie, having a mortgage allows you to save and invest more money than you otherwise would. So, I recommend taking out a mortgage and using your cash to beef up your emergency fund and save more for retirement, if you aren’t already. Otherwise, pay the credit card debt from highest to lowest interest rate. Paying off a low-rate mortgage should be the last financial priority.
Published by Debt.com, LLC