10

My situation is that I'm receiving a one time lump sum. I have two debts to pay off.

  • Debt A, interest rate 3.5%, smaller installments
  • Debt B, interest rate 4.5%, bigger installments

From this, the obvious choice would be to put the lump sum toward debt B. However, debt B's interest is fully deductible from my taxes, and I expect to pay taxes for the foreseeable future. I'm in Finland, but I'm looking for a more general answer.

So, do I take that into account? Should I consider debt B to have zero, or discounted interest?

Criggie
  • 792
  • 6
  • 14
HAEM
  • 1,556
  • 1
  • 11
  • 21

2 Answers2

18

Why zero interest? You consider the interest rate of B multiplied by 100% minus your marginal tax rate, divided by 100%. (Provided the Finnish tax system works as others with a progressive tax and the interest is deductible as "usual" costs. If that isn't the case, adjust my assumptions accordingly.)

So let's assume your marginal tax rate is 30%. Then you can get 30% of the interest of debt B back from the taxes, leaving you with 70%, i. e. 3.15%.

So after taxes, debt B is cheaper than debt A and you should pay off debt A first.

With a marginal tax rate of 22.2%, both debts have the same cost. At a higher rate, B is cheaper (as above), at a lower rate, A is cheaper.

Disclaimer again: Take the answer with a grain of salt - if the Finnish tax system contains any traps or irregularities I am not aware of, the results might be different.

glglgl
  • 5,481
  • 1
  • 18
  • 34
6

There are two basic trains of thought on reducing debt. The first is the debt snowball. That is you pay off your debts smallest to largest and use the increased cash flow to pay off the larger debts sooner. This can work surprisingly well as opposed to the other method which seems superior on the surface. Cash flow, to a person passionately committed to paying off debt, is the key to success.

The second is the "debt avalanche" this is where you pay off the highest interest rate first.

Even without the tax deductibility I might put the lump sum towards Debt A. If that lump sum would pay off, or nearly pay off Debt A. Then without question I would use the lump sum towards A.

The debt avalanche method would agree with this depending on the effective interest rate of debt B. Once you factor in the tax deduction how much are you actually paying towards that loan. If its less than 3.5%, the the avalanche method would agree with putting the money towards A.

So a little math is necessary to figure out the effective interest rate of B.

To make a clear choice what are the balances of A and B? How much is the lump sum? Will the installments decrease if the loans are paid down, or is that fixed?

Pete B.
  • 80,097
  • 16
  • 174
  • 245